(updated with clarification)
With a too-close-to-call presidential race and congressional races that are expected to maintain a Republican-controlled House and Democrat-led Senate, there are two certainties that incoming officeholders need to address — a $1.1 trillion federal budget deficit and tax reform.
Both will put retirement tax incentives and tax rates for private investment and higher-income taxpayers on the table in the search for federal revenue sources.
“We know employee benefits will be in the cross hairs,” said James Klein, president of the American Benefits Council in Washington. “There is no question in my mind that it will be item No. 1 next year, especially if you want to lower tax rates.”
Regardless of who wins the White House or how many seats in Congress change parties, “retirement policy and employee benefit plans are going to be part of the conversation in the search for revenue,” said Brian H. Graff, CEO and executive director of the American Society of Pension Professionals & Actuaries, Arlington, Va. “The fiscal cliff is not partisan.”
The fiscal cliff will come in January, thanks to a combination of expiring tax rates and automatic spending cuts triggered by the absence of a federal budget plan. Chopping more than $500 billion from the federal deficit in such an abrupt way has economists warning of painful shrinkage of an already anemic U.S. economy, along with higher tax bills for 90% of taxpayers.
Failing to address the federal deficit is not an option: Moody's Investor Service already is promising to downgrade the U.S. AAA credit rating, and there's the prospect of politically unpopular across-the-board spending cuts for most federal programs.
The increasingly desperate hunt for federal revenue is setting the stage for the first major tax code overhaul since 1986, as congressional and White House budget negotiators scrutinize every possible tax expenditure to trim or cut entirely.
Both presidential candidates said they want to lower the tax rates overall. Republican candidate Mitt Romney is proposing to fund the lower rates with fewer tax deductions, including fewer deductions for retirement savings. President Barack Obama is calling for raising tax rates for higher-income earners and capping the retirement contribution exclusion for those taxpayers. Mr. Obama has also proposed ending the carried interest deduction for private equity general partners, who could be forced to pay ordinary income tax rates of up to 35%.
If Mr. Romney is elected and follows through on his plan to eliminate any taxes on capital gains, “that could be the end to many 401(k)s because small-business owners will choose to terminate their plans and get the zero tax on capital gains instead,” said Mr. Graff, who noted that the 1986 tax reform process cut the deductibility of 401(k) contributions by 70%. “Every time they do tax reform, the retirement system comes under attack. We have to be prepared for that.”