Make no mistake, your company retirement plan is at risk if the proposed tax reform is passed. But wait…..didn’t Trump tweet on October 23, 2017 that “there will be NO change to your 401(k)”? He did tweet that, however, while the tax reform might not directly alter the contribution limits to employer sponsored retirement plans, the new tax rates will produce a “disincentive” for companies to sponsor and make employer contributions to their plans.
What Are Pre-Tax Contributions Worth?
Remember, the main incentive of making contributions to employer sponsored retirement plans is moving income that would have been taxed now at a higher tax rate into the retirement years, when for most individuals, their income will be lower and that income will be taxed at a lower rate. If you have a business owner or executive that is paying 45% in taxes on the upper end of the income, there is a large incentive for that business owner to sponsor a retirement plan. They can take that income off of the table now and then realize that income in retirement at a lower rate.
This situation also benefits the employees of these companies. Due to non-discrimination rules, if the owner or executives are receiving contributions from the company to their retirement accounts, the company is required to make employer contributions to the rest of the employees to pass testing. This is why safe harbor plans have become so popular in the 401(k) market.
But what happens if the tax reform is passed and the business owners tax rate drops from 45% to 25%? You would have to make the case that when the business owner retires 5+ years from now that their tax rate will be below 25%. That is a very difficult case to make.
An Incentive NOT To Contribute To Retirement Plans
This creates an incentive for business owners NOT to contribution to employer sponsored retirement plans. Just doing the simple math, it would make sense for the business owner to stop contributing to their company sponsored retirement plan, pay tax on the income at a lower rate, and then accumulate those assets in a taxable account. When they withdraw the money from that taxable account in retirement, they will realize most of that income as long term capital gains which are more favorable than ordinary income tax rates.
If the owner is not contributing to the plan, here are the questions they are going to ask themselves:
- Why am I paying to sponsor this plan for the company if I’m not using it?
- Why make an employer contribution to the plan if I don’t have to?
This does not just impact 401(k) plans. This impacts all employer sponsored retirement plans: Simple IRA’s, SEP IRA’s, Solo(k) Plans, Pension Plans, 457 Plans, etc.
Where Does That Leave Employees?
For these reasons, as soon as tax reform is passed, in a very short time period, you will most likely see companies terminate their retirement plans or at a minimum, lower or stop the employer contributions to the plan. That leaves the employees in a boat, in the middle of the ocean, without a paddle. Without a 401(k) plan, how are employees expected to save enough to retire? They would be forced to use IRA’s which have much lower contribution limits and IRA’s don’t have employer contributions.
Employees all over the United States will become the unintended victim of tax reform. While the tax reform may not specifically place limitations on 401(k) plans, I’m sure they are aware that just by lowering the corporate tax rate from 35% to 20% and allowing all pass through business income to be taxes at a flat 25% tax rate, the pre-tax contributions to retirement plans will automatically go down dramatically by creating an environment that deters high income earners from deferring income into retirement plans. This is a complete bomb in the making for the middle class.
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.