In the first post of this series, we discussed the approach described by the Government Accountability Office (GAO) in evaluating tax expenditures and laid out the issues that impact treating the deduction, exclusion and deferral mechanisms for tax-qualified retirement plans the same as the “spending” tax expenditures.  In this second article, we will focus on two of the critical questions posited by the GAO in the GAO Report that are intended to assist Congress with its upcoming effort to revise the Code.

What is the Tax Expenditure’s Intended Purpose?

Examples used in the GAO Report include the following:

  • To encourage taxpayers to engage in particular activities.
  • To adjust for differences in individuals’ ability to pay taxes.
  • To adjust for other provisions of the tax code.
  • To simplify tax administration.

The last example above makes for eye-rolling.  When it comes to the complex tax scheme of the qualified plan system, changes made by Congress since the promulgation of ERISA in 1974 have typically made tax administration more complex.  It is anticipated that any changes Congress would make in 2013, possibly well-intentioned, will still result in full employment for the small group of Americans who are responsible for administering the plans and the IRS’s relatively small group of agents who are charged with tax administration of this complex system.

The first example above is one that directly addresses the concerns that Congress might “cut back” on the relevant tax expenditures.  No doubt the purposes of the tax expenditures for qualified plans are to encourage employers to sponsor plans and to encourage employees to save for retirement.  The ultimate goal has always been to have a solid third leg for the three-legged retirement stool (Social Security, individual savings outside a plan, and a tax-advantaged, employer-sponsored retirement plan).  Therefore, reducing the tax expenditures would seem to be inconsistent with this purpose.  However, there are many complexities to analyzing the impact that reducing the tax expenditures might have.  For example, small business owners might be less likely to sponsor plans if they themselves cannot engage in significant deferrals.  Many employees may be less likely to save through plans like 401(k) and 403(b) plans if the tax expenditures are reduced.  Of course, many participants save in amounts less than what a cutback might represent.  For example, the current elective deferral limit of $17,500 is very high for many workers who cannot afford to reduce take home pay enough to fully fund their deferral account to the limit each year.  On the other hand, the fact that there are so many two wage earner families today might allow one spouse to fully fund her account while the other spouse saves less in his account.  However, reducing the deferral limit may well disincentivize business owners who fully fund their deferral accounts today.  Some of them may even stop sponsoring these plans depending on the depth of any cutback in the expenditures, the actual or perceived cost to them in sponsoring a plan and the competition in the marketplace to hire good workers who insist on having a form of retirement plan at their workplace.

More significant perhaps would be a reduction in the overall funding limit of Section 415 of the Code.  Today the limit is 100% of compensation to a maximum of $51,000 (plus a $5,500 catch-up potential for those who are at least 50 years old during the plan year).  The Simpson-Bowles Commission recommended a reduction to 20% of compensation not to exceed $20,000.   The tax cynic and the tax scholar would likely agree that effecting such a significant reduction would be intended for the sole purpose of raising revenue.  This purpose is not a tax expenditure purpose.  This current limits allow for significant company and employee contributions, allow for employers in successful years to reward employees with funds for retirement (profit sharing), and allow business owners the opportunity through many plan designs to fund for themselves in a way that is consonant with their expected standard of living in retirement.

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A significant reduction in the tax expenditures could have another interesting and unfortunate effect.  Due to the current income tax structure, one might view saving in qualified plans as “tax backwards.”  After all, saving through the purchase of capital assets (like mutual funds) within a plan will someday result in ordinary income recognition on the amount contributed and on the earnings and growth.  Had the business owner invested outside the plan, the growth component would be taxed at the far more favorable capital gains rates.  This “conversion” of growth from capital to ordinary can only be justified because of the tax expenditures.  Therefore, reducing them significantly could cause many business owners to terminate their plans since the plans would have less after-tax value to them personally.  Their expectation might be that they particularly, and their employees to some extent, would benefit under the tax system by taking advantage of capital gain reporting rather than ordinary income reporting.  Of course, most employees are not sophisticated in the workings of the Code to be able to measure the difference for themselves, and their savings rates would surely diminish, if not evaporate, should plans be terminated.

Ironically, Congress just raised the ordinary income tax rate on successful business people in the American Taxpayer Relief Act of 2012 (see our discussion of some of the benefits components of the act here and here).  That should mean that these high income folks will be looking for ways to shelter ordinary income, and a qualified plan is a great tool for doing so.  If Congress takes away a significant part of their ability to defer income recognition by reducing limits for qualified plans, it will be a double hit to them.  Again, one must appreciate that this tax expenditure is not a spending expenditure since Congress will eventually get back what it has “given away.”  So why give the owners of business a reason to terminate plans?  After all, won’t they be better off investing at capital gains rates if the deferral amount for them is insignificant?

The second and third bullet point examples are somewhat subsumed in the foregoing discussion.  The current system does allow for differences in ability to pay taxes by allowing flexibility in electing to defer some income and by taxing the eventual distributions within the appropriate rate brackets that otherwise tax ordinary income.  Unfortunately, Congress changes the rates from time to time, so there is no solid process for anyone, not even an actuary, to measure the value of the tax expenditures to a participant at any point in time.  And, of course, other Code provisions are impacted in no small measure due to the conversion described above and the impact of deferral on the need for raising current revenue.

One conclusion may well be that moderate to significant cuts in the tax expenditures available for saving through qualified plans would be harmful to the retirement system, might well reduce savings overall, would reduce the amount of money that flows into the markets from qualified plans, and might actually harm the federal fisc in the long run by eliminating the conversion from capital gain to ordinary income inherent in the structure.  Brian Graff, ASPPA executive director and CEO, has stated that the “last time Congress took up tax reform in 1986, contributions to employee 401(k) plans were cut by 70%.”  That resulted from a cutback in the then available tax expenditures.  Of course, most of the analyses that would identify and quantify the impact of reductions in the tax expenditures will not be done by the GAO or any other government agency since they assume impacts lasting over periods longer than the five years considered for federal budgeting.

Does the Tax Expenditure Succeed in Achieving Its Intended Purpose?

It is generally well accepted that the primary way Americans save today is through their employer-based retirement plans.  Over 60 million American workers are covered by a 401(k), 403(b), and 457(b) plans.  Eighty percent of 401(k) plan participants come from households making less than $100,000 in annual income.  71.5% of moderate income ($30,000 to $50,000) people save when a tax-advantaged plan is available at work.  Only 4.6% of this group saves when no plan is available at work and they must use the IRA structure for tax-advantaged savings.  It appears that, even with the lower paid group, the tax expenditures are fulfilling their intended purpose.  Will a significant reduction in the deferral and overall limits in an effort to raise revenue harm these results?  The lesson of 1986 suggests that it is likely and will depend on the extent of any reduction.

Unfortunately, the short-term evaluation process used by Congress is likely to provide erroneous results since the full impact of the recovery of funds to the federal fisc will not be considered in measuring the “cost” of the tax expenditures for retirement plans.  Even though it would appear that the purpose for these tax expenditures is a valid one and that the purpose is being met, there is a significant risk that Congress, while looking for revenue, will reduce these benefits effecting harm to the retirement system, the country’s investment structure (trillions of dollars are fed into American business through retirement plan investments) and the hope for a proper and dignified retirement for American workers.

We are not unmindful of the many arguments that have been made in recent years suggesting that the 401(k) plan is a flawed retirement savings structure.  And we do not disagree with the notion that it can be improved, particularly with respect to the investment structures and need for competent, professional investment advice inherent in the operation of these plans.  However, the statistics make it clear that the employer-based elective deferral structures currently permitted under the law (401(k), 403(b), and 457(b)) are the best things going for individual savings in America.  They have proved to be superb savings devices where trillions of dollars have been saved and have grown over decades of performance.  To cut the tax expenditures in a way that would harm savings rates would be counterproductive.  In the final analysis, one would have to take the position that the tax expenditures are meeting their intended purpose.