Tax law’s pass-through provision could harm 401(k) plans

The new tax law’s provision on pass-through businesses is proving to be one of the most challenging to dissect, and it’s one that some retirement pundits are eyeing with concern.

Some industry groups, such as the American Retirement Association, say the pass-through rules could become the most impactful part of the law for 401(k) plans, which were otherwise largely left untouched by the legislation.

The alarm stems from a new tax mismatch created by the rules on pass-through entities, which observers contend could lead to a slowdown in new 401(k) plan creation among small-business owners and a watering down of benefits for participants in existing retirement plans.

“We have concerns for both of those events,” said Doug Fisher, director of retirement policy at the American Retirement Association.

(More: Everything financial advisers need to know about the final bill)

Pass-throughs are businesses such as limited liability companies, sole proprietorships, S corporations and partnerships whose income is passed to owners’ tax returns, and taxed at their individual rate.

The tax law, signed Dec. 22 by President Donald J. Trump, provides a 20% tax deduction to pass-throughs. So a pass-through business owner would be able to deduct 20% of income from what is taxed. Put another way, a top rate of 37% on taxable income would become 29.6% (or, 37% reduced by 20%).

This lower rate provides a disincentive for small-business owners to stash pre-tax money in a 401(k) plan, observers argue. Their logic: Why save money in a 401(k) now and likely pay a higher rate later upon withdrawal, when the owner can pay a lower tax rate now?

Mr. Fisher argues the tax differential will deter some business owners from starting a 401(k) plan, which could, in turn, hinder business development for retirement plan advisers. He and other observers also believe pass-through treatment could drive business owners to dilute benefits in existing plans.

Some entities, especially S corporations, may be less incentivized to provide a generous company match if they can get a more economical tax break by counting that money as business income instead of a plan contribution, said Michael Hadley, partner at Davis & Harman, a firm that lobbies on behalf of financial services organizations.

“I do have a concern,” Mr. Hadley said. “I think the way the final bill came out, the concern was a lot less than it could have been.”

When the House of Representatives issued its version of the tax bill in November, the American Retirement Association estimated the pass-through provision would affect roughly 320,000 retirement plans and 24 million employees, Mr. Fisher said. The House’s pass-through rules differed from the one in the new law, though, and the organization hasn’t yet revised its estimate.

Some are skeptical the pass-through rules will significantly affect 401(k) plan creation and benefits, saying business owners typically don’t set up retirement plans primarily as a tax shelter.

“Their belief is a business owner only sets up a 401(k) as a self-serving matter,” said Aaron Pottichen, retirement services practice leader at CLS Partners, about groups alarmed with the new tax law. “In my dealing, they’re setting up a 401(k) mostly because they want to provide a benefit for their employees.”

And there are a few limitations on which businesses can receive the 20% tax deduction. The owner of a service business whose income exceeds $207,000 wouldn’t get the deduction, for example.

Mr. Hadley also points out the deduction will vary widely based on a pass-through’s business model, and that it may ultimately be more beneficial for some business owners to put money in a 401(k) now and let it grow tax-free, as opposed to getting a tax break now and saving in a taxable brokerage account.

“The actual impact of it in the real world, I think, is still to be determined,” Mr. Hadley said.