On Thursday, November 2, the House Ways and Means Committee released the text of proposed federal tax reform legislation. This bill will be debated, potentially amended, and eventually voted upon by the House. Meanwhile, the Senate is readying its version of tax reform, and assuming their legislation can be passed in that narrowly-divided body, the House and Senate must reconcile any differences between their respective bills and approve a common version. Only then could it be presented to President Trump to sign into law.
While it is understood that the version of tax reform released by the House Ways and Means Committee this week could change both in House deliberations and in a conference committee process with the Senate, it is worth taking note of the proposed provisions that would affect tax-favored savings arrangements. Also worth noting are certain provisions that were not in the Committee’s legislative text. Specifically, widespread concern that the bill would propose limiting the availability of pretax retirement savings contributions proved to be unfounded; at least, in this initial bill version. Speculation centered on a highly-publicized $2,400 cap on pretax contributions to 401(k)-type plans, which led to vigorous and coordinated opposition from the retirement industry. That provision was conspicuously absent from this Ways and Means Committee proposal.
House Proposed Changes
Following are proposed changes that would affect tax-preferenced savings arrangements, if they remain in the legislative mix through the long process that lies ahead for tax reform. (This listing does not address most business or individual tax reform provisions, which are substantial.)
Elimination of IRA recharacterizations
The ability to change IRA contributions from Traditional to Roth or Roth to Traditional IRA, or to reverse conversions from Traditional to Roth IRAs—known as “recharacterizations”—would be eliminated, and would apply for tax years after 2017.
Age 59½ would be universally available as an in-service distribution option for all tax-qualified employer retirement plans. Age 59½ in-service withdrawals currently are not permitted for pension plans (defined contribution or defined benefit) or for any governmental 457(b) plans. This would apply for plan years after 2017.
Retirement plan hardship distributions could include not only employee deferrals, but also employer qualified nonelective contributions (QNECs) and qualified matching contributions (QMACs), as well as earnings on all such contribution sources. Suspension of deferrals for six months following a hardship distribution would no longer be required, and available plan loans would not have to be taken before participant eligibility for a hardship distribution. This would apply for plan years after 2017.
Rollover of offset plan loan amounts
Employer plan loans are commonly treated as offset and taxable when a participant leaves employment or a plan terminates, with only 60 days available to make up the loan balance and execute a rollover to an IRA or to another employer plan. Under this proposal, loans offset due to separation from employment or plan termination could be rolled over by the participant’s tax return deadline for the tax year when the loan is offset. This would apply for tax years after 2017.
Defined benefit plan testing relief
The transition some employers are making from defined benefit (DB) pension plans to defined contribution (DC) plans—such as 401(k)s—can lead to potential noncompliance in terms of benefits provided to different groups of participants. This bill proposes to provide tax code-based relief, the end result of which may be to allow certain affected DB plans to be maintained rather than terminated. This would apply from the date of enactment.
529 plans/Coverdell ESAs
Coverdell education savings accounts (ESAs) could no longer receive contributions, but their balances would remain able to be rolled over to state 529 plans (qualified tuition plans). In addition, 529 plan assets, which currently can only be used for qualified post-secondary school expenses, could be used for qualifying elementary and secondary (high school) expenses of up to $10,000 per year. Assets could also be used for qualified apprenticeship programs (not subject to this $10,000 limitation). Not only could accounts be set up at any age, as is now permitted, but the proposal would allow establishing a 529 plan account for an unborn child during the pregnancy term. These changes would apply for contributions and distributions after 2017.
HSAs and Archer MSAs
The tax deductions for contributions to existing Archer medical savings accounts—the trial-basis predecessor to health savings accounts (HSAs)—would no longer be allowed, and an employer contribution made to an existing MSA would be treated as taxable employee compensation. MSA balances would continue to be eligible for rollover to HSAs. (No liberalization or increase in HSA contributions, as previously proposed in Affordable Care Act repeal legislation, is contained in this proposal.) These provisions would apply for tax years after 2017.
Concern was voiced prior to release of this tax reform proposal that it could create a disincentive for employers to establish retirement plans for themselves and their employees or to terminate existing plans. Specifically, it was the concern that a post-reform tax structure would make it more tax cost-efficient for an employer to pay current year income taxes and benefit from capital gains treatment of investments, rather than defer taxation in an employer plan and pay taxes upon distribution after retirement. That concern seems to have been tempered significantly by the details of the Ways and Means Committee’s tax reform draft. Of course, such determinations are based on facts and circumstances and it is impossible to predict at this time the exact shape of business-versus-individual income taxation in any final tax reform bill.
Under the Ways and Means Committee draft, businesses structured in a manner that generates pass-through income (e.g., sole proprietorships, partnerships, S-corporations) would be taxed at a 25 percent rate for “business income” (rather than the proposed maximum 20 percent corporate tax rate) and at individual income tax rates for compensation. In general, a maximum of 30 percent of revenues could be treated as business income and taxed at the favorable 25 percent rate, and at least 70 percent would be treated as compensation and taxed at one’s individual income tax rate (the current maximum individual tax rate is proposed to remain at 39.6 percent). A facts-and-circumstances formula could in some cases modify this 30/70 business income/compensation split. This provision would apply for tax years after 2017.
Unrelated Business Taxable Income (UBTI)
The tax reform draft makes clear that retirement plans of governmental entities would be made subject to the rules that apply to unrelated business taxable income (UBTI). There is currently some lack of clarity on this issue. In general, if a plan holds assets that generate a revenue stream, those revenues will be subject to current-year taxation. (Note that historically, it has been clear that retirement savings arrangements of entities other than units of government, such as IRAs and most employer-sponsored retirement plans, have been subject to annual taxation of revenue generated by investing in unrelated business entities.) This provision would apply to tax years after 2017.
More to Come
Ascensus will continue to observe the tax reform process as it moves forward in the House of Representatives and the Senate, and report on developments as warranted. This is just an initial proposal, subject to possible amending, alignment with a yet-to-be introduced Senate bill, and a potential conference committee process if House and Senate bills differ.