Risks to retirement industry remain despite fiscal cliff deal

Tax preferences for retirement savings remain a potential target as Congress last week removed the immediate threat of the fiscal cliff and now must address required spending cuts and long-term solutions to the growing national debt.

The deal on expiring tax cuts and other items approved on Jan. 1 by Congress in the American Taxpayer Relief Act of 2012 missed reaching a grand bargain on taxes and spending but mainly limited tax increases to high-income earners. Among the revenue-raising tax changes in the new law is one that allows for conversions to Roth plans from traditional 401(k), 403(b) and 457 defined contribution plans.

The 401(k) conversion provision was done as part of the delay, until March 1, of the spending cuts required under the sequestration portion of the law that led to the fiscal cliff.

As Congress heads toward the new deadline for cutting spending or raising additional tax revenue, there will be more threats to the retirement investment community in the coming months, said Derek B. Dorn, partner in the Washington-based law firm of Davis & Harman LLP and former senior Senate tax aide.

“Congress has delayed the fiscal cliff by erecting a new and potentially more dangerous one,” Mr. Dorn said. “The fact that retirement incentives rank second on the list of tax expenditures (behind only employer-provided health insurance) creates considerable vulnerability for retirement incentives in any tax reform process.”

Geoff Manville, principal, government relations, at Mercer LLC, Washington, said how long the financial market stays positive about what Congress has done so far will depend on where discussions go regarding further spending cuts and the debt ceiling negotiation.

He said the fiscal cliff deal “proves that anything with retirement income that raises money has legs” for future negotiations.

Congress is looking to reform the tax code and it is likely that “anything with a big tax expenditure will come under a large amount of scrutiny,” said James Delaplane, Washington-based principal for government relations at Vanguard Group Inc.

While retirement incentives are considered one of the country's largest tax expenditures, key members of Congress recognize the distinction between tax revenue deferral and tax revenue loss, Mr. Delaplane said.

He added that entitlement reform, which will be at the center of future congressional negotiations, would be helpful for retirement plans because if Social Security and Medicare benefits are reduced, it is less likely that Congress would also scale back other tax-preferred retirement savings.

The more likely risk to retirement incentives are general limits on how much in tax preferences or exemptions any individual can claim, where caps could be imposed on overall exemptions rather than a “laser focus on retirement savings,” Mr. Delaplane said. However, he said while it is not difficult to impose caps on total tax deductions, that kind of provision is more challenging to apply to 401(k) deferrals that are made on a weekly basis and not just determined in tax filings.

Plan sponsors will need to keep a close eye on the repercussions of any entitlement reforms, Mr. Delaplane said. Plans are often designed around a participant's full expected benefit, including entitlements, and any changes to Social Security or Medicare could cause plan executives to re-evaluate the benefits offered in a retirement plan.

James Klein, president of the Washington-based American Benefits Council, said there is a “myriad of different ideas out there in play” to raise revenue that could affect the retirement industry, including raising Pension Benefit Guaranty Corp. premiums, limiting the overall amount of tax exemptions and making contributions to Roth accounts more attractive.

The fiscal cliff deal signed last week allows virtually all traditional 401(k), 403(b) and 457 plan account balances to be transferred to Roth 401(k) plans. Previously a big chunk of 401(k) plan money, such as pretax contributions made by employees until they are age 59½, were not eligible for transfer to Roth 401(k) plans. The change raises money for the federal government by collecting taxes on the money moved from traditional 401(k) account to a Roth 401(k). Congress could make all future contributions flow to Roth accounts, Mr. Klein said.

With just two months left to go on a stopgap spending authorization for federal agencies and programs, “we know that more than half of the House feels pretty strongly about spending cuts,” said Scott Macey, president and CEO of the ERISA Industry Committee, Washington. “If you look at the revenue side, I suspect there'd be major concern to do further cuts on (tax) rates, and they could start to limit or phase out deductions” including those for retirement contributions from both employers and employees.

Judy Miller, director of retirement policy for the American Society of Pension Professionals & Actuaries, Arlington, Va., said it does not make sense to include both entitlement and retirement cuts, but added there is a danger that all retirement incentives will likely be looked at because it is difficult to find hundreds of billions of dollars in additional revenue.

The ASPPA was happy to see the Roth conversion included in the fiscal cliff to level the playing field between 401(k) accounts and IRAs, which have had a Roth option for years. Ms. Miller called it an “important feature,” but the group is more concerned with a proposal from the Obama administration that would put a cap on tax benefits at 28%, Ms. Miller said.

Another concern is that Congress might adopt any portion of the Simpson-Bowles National Commission on Fiscal Responsibility and Reform plan to limit tax-deferred contributions to retirement accounts to $20,000 a year or 20% of income, which Ms. Miller said would be “totally devastating.”

“We would like things to go through a regular order and not be decided by a few people in a back room,” Ms. Miller said.

Vanguard's Mr. Delaplane said the 20/20 proposal cannot be counted out, but there is little enthusiasm on Capitol Hill for it right now.

“I think we do have to be on alert that further efforts to divert pre-tax dollars to Roth are in the mix,” Mr. Delaplane said, adding it could be more palatable to some to extend the Roth treatment to more retirement savings rather than implement limits on tax deductions. Congress still needs to weigh the implications of moving more toward Roth, which would provide the federal government more tax revenue in the next 10 years, but reduce tax revenue years down the road, he said.

“It has the elements of gimmicky and short-term thinking,” Mr. Delaplane said. “It's not a long-term deficit-reduction play that makes sense.”

However, the inclusion of the Roth 401(k) conversions in the bill enacted last week has had a positive reaction in the retirement community.

Ms. Miller thinks the number of defined contribution plans that offer Roth options will increase but will not have a dramatic impact on how much assets flow into the plans.

The more important aspect is putting qualified defined contribution plans on the same playing field as IRAs, she said.

Mr. Dorn said the inclusion of the Roth conversions in the fiscal cliff law was somewhat of a surprise, but demonstrates that anything that raises revenue is on the table.

The new law also raised revenue by boosting the capital gains tax rate, which includes carried interest paid by general partners in private equity and other alternative investments, to 20% from 15%; when combined with a 3.8% surcharge on capital gains for individuals making more than $400,000 a year to pay for the new health care law, represents a 58% tax increase on capital gains, said Steve Judge, president and CEO of the Private Equity Growth Capital Council, Washington.

Mr. Judge said his group will be urging “that any tax reform effort in 2013 be about crafting policies that incentivize economic growth.”

Reporter Hazel Bradford contributed to this story.