Tax reform and deferred comp – what’s the potential impact?
Keeping you, your clients and their participants updated
Federal tax reform is a hot topic in Washington, D.C. – and across the country. As our political leaders debate tax-code changes (as well as infrastructure and healthcare), many are left wondering how it could impact our lives, including businesses and key employees – and what that could mean for nonqualified deferred compensation plans.
While nothing’s in stone to date, we want to keep you informed and updated, so you can continue to confidently talk with your clients about the value of deferred comp plans – with or without tax reform.
The latest – as of late-May 2017
- Tax reform will be a bumpy ride on Capitol Hill, and it may be difficult to make substantial progress in 2017 – perhaps even into 2019.
- Deferred comp plans will remain valuable in helping key employees save for retirement and other goals. Plus, tax reform could make sponsoring a plan less costly for employers of all types and sizes.
- The comparative economics of financing a deferred comp plan may be affected, depending on how significant the change is to corporate tax rates.
Let’s take a closer look at what this means.
Potential tax reform
Despite all the political jockeying, it may be difficult to move tax reform forward in Congress within the next couple of years. Here’s why:
- All tax legislation starts in the House of Representatives. As the tug-of-war over repealing the Affordable Care Act (ACA – also known as Obamacare) has shown, it will be difficult to pass a tax bill that significantly adds to the deficit. Even if a tax bill can get through the House, it must also pass in the Senate.
- In order to pass permanent tax legislation in the Senate, 60 votes are needed. Unless a bipartisan agreement is reached, it will be difficult to rally that count.
- What appears more possible is a Senate procedure known as reconciliation. Under this, the Senate can pass tax legislation with a simple majority – if two conditions are met:
- The tax provisions are only in effect for less than 10 years.
- The bill is “revenue neutral”, meaning it doesn’t add to current deficit projections.
- There are three obstacles for getting to revenue neutrality:
- The House has proposed a Border Adjustment Tax that would raise more than one trillion dollars over 10 years. But there’s been pushback on this proposal – mainly from employers who heavily rely on imported goods. And in the Senate, Republicans have expressed opposition.
- Although healthcare reform has passed in the House, it may have difficulty reconciling with the Senate version. And losing that projected decrease in expenditures would make a deficit-neutral budget even harder.
- Even with those issues “solved,” there would be a potentially massive revenue shortfall to be recovered by either other revenue sources or spending cuts.
And then there’s the question of timing. As we approach mid-year, the Senate has indicated it’s “starting from scratch” on its version of healthcare – while the Senate Finance Committee is working on its version of tax reform. So it’s difficult to see healthcare and tax reform being accomplished before the end of 2017. And with mid-term elections in 2018, some politicians may not be eager to cast votes on these hot topics.
Potential impacts on deferred comp
If tax reform would actually happen:
How would it impact plan participants?
- Under the Trump administration’s tax-reform proposal, the highest marginal income-tax rate would fall from 39.6% to 35%. When you consider this proposal would also eliminate the federal deduction for state and local taxes, some participants’ marginal tax rates could actually increase.
- Capital gains taxes would decline somewhat, and the 3.8% tax on unearned income would be eliminated – making after-tax investing somewhat more attractive.
- There are proposals on Capitol Hill that would convert all 401(k) plan contributions to a Roth IRA, meaning current tax would be due on contributions – but not upon distribution.
We believe contributions to a deferred comp plan would still be attractive to plan participants. Overall, marginal rates (especially in high tax states) would still be relatively high. And the relatively small reductions in capital gains taxes would not offset the benefits of tax-deferred earnings. And if 401(k) plan contributions were further restricted, deferred comp would offer the only way for key employees to save on a pre-tax basis.
How would it impact plan sponsors?
- Under the Trump Administration’s proposal, C corporations would be taxed 15%.
- Owners of S corporations (and other types of tax pass-through entities) would be taxed 15% for business income. While this wouldn’t include all pass-through income, it could significantly reduce the pass-through owner’s tax amount.
- The delayed tax deduction for deferred comp contributions would remain unchanged. Unlike contributions to qualified plans that are currently deductible, deferred comp benefits are only tax deductible when distributed.
These significant tax reductions would dramatically lower an employer’s long-term cost to sponsor a deferred comp plan. The cash flow required to support the delayed tax deduction would be much lower than under current law. Although it’s unlikely that a 15% corporate rate would make it into law, even a reduction to 20% or 25% would have a positive impact on employers’ cash flow.
How would it impact plan financing?
Deferred comp plans are unfunded plans under the Employee Retirement Income Security Act (ERISA). This means that any assets set aside to informally finance the promised benefits remain on the employer’s balance sheet and are subject to taxation as required under the tax code. Typically, deferred comp plans are informally financed with taxable mutual funds or corporate-owned life insurance (COLI).
If there’s a significant change in corporate tax rates, this could affect the comparative economics of deferred comp plan financing:
- If corporate tax rates fall to around 25% (combined state and federal), COLI will generally compare somewhat favorably to mutual fund financing, but the advantages will only be realized if held by the employer for a longer time horizon.
- If corporate tax rates fall to 20% or below, mutual funds will tend to look economically better on a present value basis. This, of course, will be dependent on the various assumptions that are being modeled.
- It’s good to remember that COLI provides other benefits, including cost-recovery and/or key-person coverage, that may be desirable outside the deferred comp plan. So, be sure to look at the economic variables, as well as any other needs of the employer.
For financial professional use only. Not for distribution to the public.
The views expressed are those of Principal® and provided with the understanding that Principal ® is not rendering legal, accounting or tax advice. The content is provided as informational only and is based on our general understanding of the relevant technical and political issues as of the writing. This information is not intended nor should it be used as an opinion on legal, accounting or tax issues.
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