Tax reform: How the House bill changes rules for retirement savings

While pre-tax 401(k) contribution limits are off the table (for now), the Republican tax bill nonetheless makes changes to retirement savings plans

Nov 3, 2017 @ 4:38 pm

By Greg Iacurci

The headline news for retirement plan advisers Thursday upon the unveiling of the House tax bill was that a reduction in the pre-tax 401(k) savings limit is off the table, for now.

But there are plenty of other details in the tax-reform legislation, the Tax Cuts and Jobs Act, that would affect retirement savings. Here are the most important points.

Loans

The tax bill, released Nov. 2, would lengthen the time frame employees have to pay back a 401(k) loan without penalty if they leave the firm or the plan terminates.

Under current rules, if a worker in such circumstances doesn't pay back a loan within 60 days, the loan is treated as a taxable distribution. It's also subject to an additional 10% penalty if the employee is under age 59½.

The bill would extend that time period, giving participants until the due date for filing their tax return for that year to contribute the loan balance to a retirement account. For example, an employee leaving in January 2018 would have until April 2019 to repay the loan.

(More: Why the House tax bill could be a 'bonanza' for advisers)

Hardship distributions

The bill makes a few big changes to 401(k) hardship distributions.

First, it allows participants to continue saving in their retirement plan upon taking a hardship distribution; under current rules, employees must suspend their contributions for six months.

Second, it permits plan sponsors to allow participants to take a hardship withdrawal from two additional pots of money: account earnings and employer contributions. Currently, they may only come from an employee's contributions.

Susan Shoemaker, partner and head of the defined contribution practice at Plante Moran Financial Advisors, said she is "on the fence" about the latter hardship provision because it could potentially lead some participants to abuse hardship distributions. However, she likes the change allowing continued contributions after hardship withdrawals.

In-service distributions

State and local government defined contribution plans, as as well as all defined benefit pension plans (in the private and public sectors), would be allowed to make in-service distributions when participants are age 59½. That's a change from current rules, which require particpants to wait until age 62.

The proposed law would bring pensions and public DC plans in line with current 401(k) rules.

"That's actually kind of a big deal," Brian Graff, CEO of the American Retirement Association, said.

"People could do earlier phased retirements," Mr. Graff said, but also raised the concern that the rule would contribute to leakage from retirement plans at a time when people haven't yet reached retirement age.

Recharacterizations of Roth IRA conversions

A recharacterization of a Roth IRA conversion would no longer be allowed. A Roth conversion allows a taxpayer to convert a traditional, or pre-tax, individual retirement account to an after-tax account, and is a widely used strategy among financial planners. A recharacterization undoes the conversion.

KEEP AN EYE OUT

Pre-tax limits

There are some important items to watch out for in the weeks ahead as the House bill moves through committee, the Senate proposes its own tax legislation, and the two ultimately try reconciling differences.

While some are cheering that the House bill didn't reduce the pre-tax savings limit on 401(k) plans, they're not done worrying just yet.

"The good news is that the bill omits the Rothification proposal — no limit on pretax contributions," said Mark Iwry, former senior adviser to the secretary of the Treasury and deputy assistant secretary for retirement and health policy at the Treasury Department. "But this is not the time for complacency. It's still a dynamic process, and the retirement community needs to keep a sharp eye on it, in the House in particular."

Pass-through entities

Prior to the bill's release, there had been concern among retirement industry circles that a tax rate of 25% for all pass-through businesses would lead some business owners to ditch their 401(k) plans.

The thought here was: Why would a business owner paying taxes at the top rate of 39.6%, for example, choose to defer retirement savings? Instead of paying 39.6% on those savings later, the owner of that pass-through business could pay a 25% rate now.

That tax mismatch caused concern that 401(k) plans would prove less valuable to those owners. However, some observers are initially optimistic because the House bill's treatment of pass-throughs came with several restrictions.

"It's extremely complicated, so we're carefully evaluating," Mr. Graff said. "But our first reaction is we're optimistic retirement incentives will remain in place for business owners."

Auto-IRAs

Senate Democrats unveiled a few retirement provisions they would like to see as a part of tax reform, one of which is a federal automatic-enrollment IRA program for workers without access to a workplace savings plan.

These sorts of plans have been enacted in five states — Oregon, California, Illinois, Connecticut and Maryland — as a way to close the workplace coverage gap.

However, they remain contentious among some industry groups such as the Investment Company Institute and the Financial Services Institute. Plus, Republicans are trying to pass tax reform without the help of Democratic votes, and ostensibly wouldn't have to add in sweeteners such as an auto-IRA provision to pass their bill.

But, some are optimistic the provision could make it into a final bill.

"It's ready to go, cheap, and furthers the bill's stated goals of helping the middle class while growing the economy," Mr. Iwry, a proponent of these plans, said. "Tax reform is a sea change; various things could play out."

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