As the 112th Congress convened in January, it was clear that a substantial part of the legislative agenda for the next few years will be to address our nation’s long-term fiscal challenges which arose from our mounting Federal debt. Although dramatic reforms are not expected this year, it is likely that the current economic conditions will result in significant changes to the tax code. These revisions could diminish many of the tax incentives in retirement plans that we have long taken for granted. If so, this will likely hinder workers and their ability to adequately save for retirement.
Tax Reform and Simplification of Private Retirement System
A familiar approach to addressing the federal deficit is tax reform. In a recent speech, President Obama called on Congress “to undertake comprehensive tax reform that produces a system which is fairer, has fewer loopholes…” While much of Washington differs on whether to lower tax rates or raise additional income without increasing rates, most seem to agree that to “broaden the base” (restrict or eliminate current income exclusions so that additional income may be subject to taxes) would greatly increase federal tax receipts.
Broadening the income subject to federal taxes would result in activities that have preferential tax treatment to no longer enjoy a favored position in the Internal Revenue Code (IRC). One area where a significant impact might be felt is on tax deductible contributions of qualified retirement plans (by both employers and employees). The private retirement system is a large target to those that support this approach as it is projected to be the largest “tax expenditure” in the IRC by 2013.
There have already been several recommendations put forward by multiple organizations including the National Commission on Fiscal Responsibility and Reform and the President’s Economic Recovery Advisory Board to address reform of the private retirement system. Among the proposals is the consolidation of the multiple types of retirement plan coupled with a reduction and targeted approach to the tax incentives inherent to them. This recommendation included the fusion of different retirement account types into a single plan design with an annual additions limit of 20% of compensation or $20,000. This limit would represent a significant reduction from the current Section 415 limit of $49,000 for defined contribution plans. The proposal further suggested simplifying qualified plan non-discrimination testing.
Congress, the Administration and the opposing political parties may wrestle over the many peripheral issues in the budget, but the 800 pound gorilla in the room is entitlement programs such as Social Security. If, once and for all, Social Security’s issues could be addressed in a meaningful way, it would have a sizable impact on the reduction of long-term deficits and to improve the future security of America’s retirees. In 2010, Social Security paid out more in benefits than it took in through payroll taxes. This disparity and the risk of insolvency create concern for workers over what will be available for them in the future. Addressing these public retirement system challenges would go a long way to restoring the public’s confidence in our nation’s finances.
Over the years, dozens of proposals have claimed to provide a solution to Social Security’s financial ills. Some of the more substantial recommendations gaining attention include:
- Indexing the full retirement age beyond 67 years old to improvements in longevity
- Switching to an inflation adjustment that rises more slowly than the current rate (CPI) used to calculate the annual cost-of-living adjustment
- Increasing the taxable wage base that exposes the amount of earnings subject to payroll tax (and the basis for benefits) to about $180,000 from the current $106,800
- Subjecting both employer and employee premiums for group health insurance to payroll and income taxes
Given the new balance of power in Washington, there may be uncertainty as to how any future efforts to address our fiscal challenges will affect our public and private retirement system. Many believe the private retirement system could come under attack as a means to alleviate the mounting federal budget deficit. Those that wish to effect changes to the private retirement system often neglect to reveal the many facts and successes of the current system, namely:
- The exclusion of retirement savings is a deferral not a permanent write-off like other deductions and exclusions. Further, deductible employee and employer dollars contributed to a plan are taxed in the future when withdrawn.
- Tax savings resulting from plan contributions is critical to encouraging small employers to establish and maintain a qualified plan.