401(k) deductions OK, but endowments, public funds find rude surprise
The first chapter in the Republican tax reform effort, launched in early November, brought surprises, with the prospect of many more to come in the near future.
Some of those surprises were good, such as keeping tax preferences for retirement savings in 401(k) accounts instead of a shift to Roth accounts.
Others caught many sectors off guard, including university endowments, private equity firms, public pension funds, many types of bond issuers and highly compensated employees.
The House Ways and Means Committee went first, approving its Tax Cuts and Jobs Act legislation along party lines on Nov. 9. That same day,the Senate introduced its version, which the Senate Finance Committee plans to take up Nov. 13.
The House version left untouched the tax treatment of 401(k) contributions. So did the Senate's proposal, with one unwelcome wrinkle: It does not allow people earning $500,000 or more annually to make catch-up contributions, even after-tax ones. Defined contribution advocates worry that sets a dangerous precedent for means-testing plans that could eventually lead to lower contribution caps for more people.
As both chambers struggled with wholesale changes to both individual and corporate taxes, growing sensitivity over who stands to benefit or lose from the tax law changes led to numerous revisions to the House measure that make it less likely Republicans would be able to stay within the $1.5 trillion cost limit required for passage of a final package. That, in turn, turns up the pressure to find more sources of tax revenue to offset tax breaks, which could still include reduced incentives for pre-tax retirement savings.
"We are not resting on our laurels. Right now, they felt they had enough revenue but that could be changing as we're speaking," said Ken Raskin, a partner at law firm King & Spalding in New York and board chairman of the Plan Sponsor Council of America. "We are still worried for this bill and we will be watching the Senate's bill too," Mr. Raskin said. The PSCA is part of Save Our Savings, a broad industry coalition formed for the tax reform battle.
"The 401(k) industry needs to stay vigilant. It is still a long road, and there are going to be almost daily worries," said Bob Melia, executive director of the Institutional Retirement Income Council, a non-profit retirement industry think tank of plan advisers, consultants and service providers.
'Rothification' fears fade
Dennis Simmons, executive director of the Committee on Investment of Employee Benefit Assets in Washington, thinks the fear of "Rothification" has faded somewhat as policymakers and staff hear from plan executives and other retirement advocates. The fact that CIEBA members — chief investment officers at 104 large companies responsible for nearly $2 trillion in retirement assets — would not be comfortable defaulting people automatically into Roth accounts, and that the nation's retirement savings levels could suffer, "I do think has resonated," he said. "Senior senators have indicated they would fight tooth and nail if Rothification surfaces.
"It's not a Democrat or Republican thing, it's a savings thing," he said.
Still, said Howard Gleckman, a senior fellow in the Urban-Brookings Tax Policy Center at the Urban Institute in Washington, the idea of shifting to Roth accounts "is certainly out there."
Under the House Republican plan, retirement plan participants benefit from rule changes for 401(k) hardship withdrawals and loan repayments. Plan sponsors get some relief on how to test partially frozen defined benefit plans for non-discrimination, and on providing make-whole contributions to defined contribution plans when defined benefit plans are frozen.
"Over time, you run into a discrimination problem, so that's something that makes a lot of sense," said Mr. Raskin of PSCA. While the legislative fix was needed, said Mr. Simmons of CIEBA, it helps "at the margins."
Higher compensated employees were not so lucky in the Senate plan, which would effectively end non-qualified deferred compensation plans that employers offer to higher paid workers. The House rejected a similar approach.
As more defined benefit plans get closed, that will be a bigger deal, said Robyn Credico, defined contribution practice leader for Willis Tower Watson PLC. "We hope they'll reconsider the changes for non-qualified plans. It is not going to help a lot of people save meaningfully for retirement," she said.
Mr. Raskin added: "Although the intention may be to limit deferrals by the highly paid, who is highly paid is defined differently depending on a person's situation and where the person lives. We don't think that this provision makes sense."
Private college endowments were even unluckier. While private foundations got a small tax cut on their investment income, private colleges and universities got a new tax bill for theirs. Under the House and Senate proposals, those with at least 500 students and assets of more than $250,000 per student would now pay 1.4% on net investment income, which the Joint Committee on Taxation estimates could bring in $3 billion in new tax revenue over the next 10 years. Along with the new tax revenue, the move reflects growing criticism in the Senate of how affluent university endowments use their tax advantages. The House plan goes one step further, spelling out that the tax would apply to income on investment assets held by organizations "related to the university," not just held directly. The proposed changes, said National Association of College and University Business Officers President and CEO John Walda, are "a disproportionate and unprecedented hit on the tax-exempt sector."
Executives at public pension plans and other state and local entities were equally shocked to learn they could soon have to pay taxes on income earned from investments, as early as 2018. The House wants to expand the rules on unrelated business taxable income, or UBTI, reversing a long-held belief their status as tax-exempt public entities under another tax code section covers investment income as well.
It would also upend a preference of some state pension funds to invest directly in hedge funds, private equity funds or other taxable vehicles, with confidence in the pension fund's tax-exempt status, which the House bill would take away.
That prospect has sent officials at public pension funds, like the $94 billion North Carolina Retirement Systems in Raleigh, scrambling to calculate how it will affect them.
In addition to worrying about how the potential compliance costs would affect portfolio construction and benefit payments, state pension officials are questioning the constitutionality of the federal government imposing taxes on state or local governments' after a history of immunity.
You win some ...
Private equity, real estate and venture capital firms won a cut in the tax treatment of pass-through business income for partnerships in the House version, down to 25% from the current individual rates up to 39.6%. The Senate version calls instead for a 17.4% deduction that would benefit more income groups.
That victory was overshadowed by the House plan to no longer let them deduct more than 30% of the interest expense for portfolio companies in a single-tax year, even as corporations could immediately write off capital investment expenses.
With debt a predominant way to finance acquisitions, reducing the deductibility of interest "would essentially restrict their access to capital. And it would have a more dramatic impact in a downturn when you need access to capital the most," said James Maloney, spokesman for the private equity advocacy group the American Investment Council, Washington. "Any short-term benefit of raising revenue for tax reform would be negated by the proven, long-term negative economic impact" if it results in higher net cost to businesses, he said.
The tax reform debate promises to get even more complicated and contentious as both chambers work to pass their respective bills, and then find enough common ground to produce a final package.
"A lot of this is so complicated and the Senate bill is going to be significantly different than the House bill," said Mr. Gleckman from the Urban-Brookings Tax Policy Center, who sees fiscally conservative Republic senators playing a key role.
Despite Republicans' pledge to get tax reform done this year, "getting that right is going to take a lot of time," he said. "They promised they'd simplify the code. What they're trying to do is combine a lot of politically popular tax cuts with a lot of unpopular tax increases. It's actually making it more complicated for some people," said Mr. Gleckman.