For the last few weeks, U.S. tax reform deliberations put 401(k) retirement plans on a roller coaster ride. Rumors abounded, including, for example, whether legislators would impose new contribution caps, or eliminate pre-tax contributions altogether. Legislators often have targeted the tax-advantaged status of retirement savings plans as a revenue raiser to pay for federal programs and competing tax breaks. The House Republicans’ release of the Tax Cuts and Jobs Act (the “Act”) on November 2 appears to have stopped the roller coaster – at least temporarily.
The Ways and Means Committee is touting that the “bill retains the popular retirement savings options – such as 401(k)s and Individual Retirement Accounts – as Americans know them today.” This is clearly the case. However, claims that there are no changes to 401(k) or other retirement savings plans are not quite accurate. While the current version of the Act does not lower 401(k) contribution limits or require the Rothification of 401(k) plans as had been rumored, it does contain some changes to retirement savings rules – many of which are pulled from the 2014 tax reform effort spearheaded by former Ways and Means’ Chairman Dave Camp. Most of these provisions appear to have been included to accelerate the tax inclusion of retirement savings and, as a result, reduce the Act’s price tag.
- Re-characterization of Roth IRA Contributions. The bill eliminates a rule that allows taxpayers to re-characterize traditional IRA contributions as Roth contributions – and the reverse – until the due date for the individual’s income tax return for the year of the contribution. As a result, taxpayers who have converted traditional IRA contributions to a Roth IRA will not be permitted to unwind the conversion even if the Roth IRA investments have produced net losses. In such cases, the up-front tax breaks given to traditional IRA contributions likely are preferred over the tax-free earnings provided to Roth IRAs. Eliminating the opportunity to re-characterize the Roth IRA as a traditional IRA reduces the tax costs associated with pre-tax IRA contributions – increasing the government’s tax revenues in the current year. The tax costs associated with Roth IRAs do not come due until amounts are distributed and, consequently, are likely to fall outside the 10-year budget-scoring window.
- In-Service Distributions at 59½. The bill lowers the age at which qualified pension plan participants who are not terminating employment may take a distribution – from age 62 to age 59½. The age for participants in Code section 457 plans, sponsored by state and local governments, is lower as well for in-service distributions. Again, by allowing earlier distributions, this provision potentially accelerates the timeframe for taxing such distributions under 457 plans.
- Hardship Distributions. The bill calls for new regulations that will eliminate a rule preventing 401(k) plan participants from making plan contributions for 6 months after receiving a hardship distribution. It also expands the pool of 401(k) funds that participants can draw upon for hardship distributions. Under the Act, hardship distributions can come from qualified matching contributions and qualified non-elective contributions, in addition to employer contributions and elective deferrals.
- Loan Rollovers. The bill gives qualified plan participants with outstanding plan loans more time to repay the loans when they terminate employment, and upon the plan’s termination. In these situations, the current law generally deems a distribution to the participant of the outstanding loan amount to have occurred, and that amount is off set against the participant’s accrued benefit. The bill also extends the period of time during which a participant may contribute a plan loan offset amount to an eligible retirement plan as a rollover contribution, thereby avoiding inclusion in income and early distribution penalties. The time-frame extension is from 60 days to the due date (including extensions) for filing the Federal income tax return for the taxable year in which the plan loan offset occurs.
- Nondiscrimination Rules for Soft-Frozen Defined Benefit Plans. Defined benefit plans that are closed to new employees but allow existing employees to continue accruing benefits often run afoul of applicable nondiscrimination rules over time as the percentage of highly compensated plan participants The Act provides non-discrimination testing relief to these plans if they increase benefits under the defined contribution plans in which new employees participate and meet other requirements.
Despite these proposed changes, 401(k) plans and IRAs have escaped the tax reform chopping block for the time being. However, the roller coaster ride could start again shortly; it is virtually impossible to predict if and how the current provisions will change. As proponents of existing tax-breaks that did not escape the chopping block continue to advocate for reinstatement of those tax breaks, new revenue sources to finance the Act’s tax cuts and other costs could be back in play. Tax advantaged retirement savings historically have been a favorite target of legislators when trolling for offset dollars. Stay tuned, the roller coaster ride very well may continue during the upcoming Ways & Means Committee’s mark-up of the bill.