Tax reform anomaly could diminish some companies' need for 401(k) plan

A dichotomy in the tax treatment of retirement deferrals and business income could discourage creation, maintenance of plans by some pass-through entities

Sep 28, 2017 @ 2:28 pm

By Greg Iacurci

The Republican tax-reform framework released Wednesday has led to concern within some retirement industry circles that plan creation and maintenance — and plan advisers' businesses — would be negatively impacted by its policy details.

The template, issued by the Trump administration and congressional committees to help guide a rewrite of the nation's tax code in the coming months, would dissuade some business owners from having a 401(k) plan due to a dichotomy in the tax treatment of business income versus savings, observers argue.

Pass-through entities, whose income is reported on business owners' individual tax returns, would be taxed at a maximum rate of 25%. However, the deferred 401(k) savings of those same wealthy business owners would be taxed at 35%, the top marginal tax bracket identified in the Republican framework.

Brian Graff, chief executive of the American Retirement Association, said this 10% difference amounts to a "tax penalty" on deferred retirement savings, and would make paying the tax up front more appealing.

"There's never any financial scenario where it makes sense to defer at that point," said Mr. Graff, also executive direction of the National Association of Plan Advisers.

The value of a retirement deferral is contingent on tax rates matching on the front and back ends of a retirement plan, he said.

Mr. Graff questioned why a business owner would opt to pay a "penalty" on retirement deferrals, maintain fiduciary liability for sponsoring a 401(k) plan and assume the administrative costs.

"We can't let this fall under the radar, otherwise there's no reason for these business owners to have a retirement plan anymore," Mr. Graff said. "No plans, no need for an adviser."

(More: 'Rothification' to pay for tax cuts seen as losing momentum, for now)

Pass-through entities, which include businesses structured as sole proprietorships, partnerships, limited liability companies and S Corporations, represent 90% of U.S. businesses and are responsible for more than half of private-sector jobs in the country, according to a Tax Foundation analysis.

However, a survey published this year by the Pew Charitable Trusts shows that while taxes do factor into employers' reasoning for offering a retirement plan, it's not necessarily the determining reason.

Nearly 60% of the 1,600 small and midsize employers surveyed indicated providing tax advantages for company management was a reason for offering a plan, but that was fourth in line behind helping employees save for retirement, having a positive impact on employee performance, and helping attract and retain employees. Only 5% said it was the main reason for offering a plan.

"Do tax advantages matter? Sure. But there's a constellation of reasons why business owners offer a retirement plan, and I think we need to look at this issue more holistically," said John Scott, director of retirement savings at Pew.

Aaron Pottichen, retirement services practice leader at advisory firm CLS Partners, doesn't believe the disparity in tax rates would dissuade most business owners from sponsoring a 401(k) plan.

The argument, he said, presupposes an individual would be in the 35% marginal tax rate in retirement; however, many individuals' income in retirement is often less, roughly 60-70% of their pre-retirement income, he said.

"At the end of the day, ultimately if someone is determining whether they should save in a 401(k) or not, that should be based on the financial plan, not tax incentives," Mr. Pottichen said.

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