Tax reform and deferred comp – what’s the potential impact?
What we know as of mid-September 2017
With the debate on health care on the back burner, the hot topic now is comprehensive federal tax reform. As our political leaders debate changes, many are left wondering what impact it will cause on businesses and key employees—and what that could mean for nonqualified deferred compensation plans.
While a lot is still in the works, we want to keep you informed and updated. So you can continue to confidently talk with your clients about the value of deferred comp—with or without tax reform.
In our opinion—why tax reform is not likely to happen soon
Tax reform is facing many hurdles on Capitol Hill in recent months, making significant progress in 2017 more difficult. And there’s potential to delay into 2019 due to the mid-term elections in 2018. Here’s why we don’t think it will happen soon:
- There's a very full agenda in Congress with not much time to consider discretionary legislative initiatives, such as comprehensive tax reform during the remainder of 2017. Although Congress did pass a three-month extension of government funding and raising the debt ceiling, more “must-do” legislation is on the docket through the end of the year, as well as many controversial topics, such as immigration reform.
- Health care reform is (at least for the time being) on hold, with the GOP short on votes to move ahead with any Senate version of the bill. President Trump and congressional Republicans have said they intend to apply savings from the health care bill to tax reductions. This, again, complicates the timing on when tax reform may take place.
- With any version of tax reform, there will be winners and losers. The proposed Border Adjustment Tax would hurt companies that import goods. Eliminating the state and local tax deduction would hurt taxpayers in higher tax states. Limiting the mortgage interest deduction might harm the housing industry. The list could go on. In a highly charged political environment, and in a mid-term election year, making the difficult votes on tax reform becomes even more difficult.
How tax reform could affect deferred comp
Focusing on the directionally common proposals coming out of both Congress and the Administration, let’s take a look at their potential impacts on participants, sponsors and plan financing.
Plan participant impacts
Tax proposals currently under consideration:
- Under the Administration’s tax reform proposal, the highest marginal income tax rate would fall from 39.6% to 35%. Considering 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 limit contributions to 401(k) plans or convert some or all contributions to a Roth arrangement, 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. Under proposals put forward by both Congress and the Administration, overall marginal individual tax rates (especially in high tax states) would still be relatively high. And any small reduction in capital gains taxes would not offset the long-term benefits of tax-deferred earnings. Another consideration—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.
Plan sponsor impacts
Tax proposals currently under consideration:
- Under the Administration’s proposal, C-Corporations would be taxed 15%. Many in Congress believe it will be difficult to get a rate down, even to 25%.
- Owners of S-Corporations (and other types of tax pass-through entities) would be taxed at lower rates 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.
So, any significant reductions in corporate tax rates could dramatically lower an employer’s long-term cost to sponsor a deferred comp plan. The cash flow required to support the delayed tax deduction could 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.
Plan financing impacts
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.
The good news continues to be that deferred comp plans will remain valuable in helping key employees save for retirement and other goals. And depending upon the outcome of tax reform, it could make sponsoring a plan less costly for employers of all types and sizes.
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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