President Trump's four principles for tax reform—simplicity, tax cuts for workers, job creation and repatriation of wealth—form the core of the recently published framework to update the tax code. To the relief of many of us concerned about preserving the important benefits of employer-provided 401(k) plans, there was no mention of a mandate that all or a portion of 401(k) contributions be directed to an after-tax Roth account.
This was a pleasant surprise, since after-tax Roth accounts seem to be the weapon of choice for plugging budget-scoring gaps. Instead, the framework simply notes that tax benefits that encourage retirement security will be retained.
Now, much work needs to be done if this framework is ever to lead to tax writing and legislation, and there will be heated debate—and tweets—along the way. After-tax Roth provisions may resurface as an illusory (read: FAKE) way to generate revenue.1 So it’s worthwhile to take a minute to acknowledge a few key points about 401(k) plans beyond the pre- or post- tax issue.
First, when it comes to encouraging retirement security, the 401(k) plan reigns supreme, with over $5 trillion held by millions of primarily middle-class workers. The vast majority of 401(k) plan participants earn less than $100,000 per year, and 43% make less than $43,000. And what’s helping drive these middle-income savers to save? Data from the Employee Benefits Research Institute shows that while more than 70% of lower- to- middle income workers save in their employer-provided retirement plan, less than 5% of these workers with no workplace plan save in an IRA.
The Stakes Are High for Small Business Owners
Employer-sponsored retirement plans offer a host of benefits and protections to employees, but this statistic underscores that the simplest, and perhaps most underrated, is payroll deduction. The demise of the myRa, the Obama-created starter savings account, reminds us that setting up a retirement savings account—whether through a visit to a Treasury website or the local bank branch—requires a level of awareness and motivation that many workers may lack.
Second, while the vast majority of workers of all income levels are enthusiastic about the many benefits offered by their retirement plans, the employer is the linchpin. Small business owners assume administrative duties, costs and fiduciary responsibility when sponsoring a retirement plan for their employees, and naturally expect to share in the benefits. The tax reform framework includes a provision that would significantly reduce the tax rate on pass-through income for entities like partnerships, S Corps and small business LLCs, more than 600,000 of whom currently sponsor retirement plans.
With a significant disparity between the pass-through income tax rate, ordinary income tax rate, and the rate on capital gains, small business owners won’t need an accountant to deduce that they fare better by paying 25% on pass-through amounts, and owing only 20% on taxable gains on amounts invested, rather than contributing to a retirement plan. Retirement plan contributions and deferred earnings would be subject to a top rate of 35%. Business owners may come out ahead financially by dropping their qualified plans; but the many retirement plan participants covered by these plans will suffer.
As the horse trading for tax preferences on Capitol Hill begins in earnest, we—and our elected representatives—should be mindful that the future success of employer-provided payroll deduction 401(k) plans hinges on more than whether or not contributions are made before taxes.
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- ^Income taxes on distributions from tax-deferred assets are generated outside the 10-year budget window. Roth accounts “raise” revenue by recognizing tax income within this window.
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These views represent the opinions of OppenheimerFunds’ Head of Retirement and Third Party Distribution and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.