GOP Tax Bill Spares 401(k)s but Kills Other Benefit Deductions

Deduction for employer-provided tuition assistance and tax exclusion for dependent care FSAs would go

By Stephen Miller, CEBS Nov 2, 2017
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updated on Nov. 16, 2017

Update: House Bill Passes While Senate Moves Forward

The House passed its version of tax reform by a vote of 227-205, with no Democratic support, on Nov. 16.

Senate Republicans released their proposal for tax reform on Nov. 9, and the bill was "marked-up"—and substantially revised—by the Senate Finance Committee during the week of Nov. 13. See the SHRM Online article Senate Tax Bill Altered to Kill the ACA's Individual Mandate.

The Senate is expected to vote on its bill the week after Thanksgiving. If it passes the Senate, both chambers would work to reconcile the differences between their bills.


House Republicans on Nov. 2 unveiled their long-awaited tax bill, which leaves in place the full pretax contribution rates for 401(k) retirement plans—$18,000 for 2017 and $18,500 for 2018, plus an additional $6,000 "catch-up" for those ages 50 and older.

But the proposed H.R. 1, the Tax Cuts and Jobs Act, does strike at other workplace benefits. It proposes, for instance, eliminating the deduction that employees can claim under tax code Section 127 for employer-provided education assistance—employees would pay income tax on the benefit and employers would pay the applicable FICA tax—and would make sweeping tax changes to a host of other employee benefits. 

The House Ways and Means Committee posted a section-by-section summary of the bill.

401(k) Contributions Spared

For weeks, there have been reports that Republicans were considering capping pretax 401(k) contributions, including many that referenced a new annual limit as low as $2,400. Contributions above the cap would have been made to a Roth 401(k) account.

Money deposited to a Roth 401(k) is taxed; account holders can then withdraw the money in retirement and not pay taxes on it again. A "traditional" 401(k) is funded with pretax dollars and withdrawals are taxed as income during retirement.

"Promoting savings, investment and economic growth is the goal of tax reform and retirement plans are how Americans save and invest," said James A. Klein, president of the American Benefits Council in Washington, D.C., which represents benefit plan sponsors. "We are gratified today's proposal lets workers save for retirement in the way that best meets their financial security needs."

"This is welcome news for plan sponsors and plan participants," said Robyn Credico, Washington, D.C.-based director of defined contribution consulting at Willis Towers Watson, an HR advisory firm. "We believe the purpose of tax reform is to put more money in people's pockets, in which case employers can consider encouraging people to save more."

"Some tax reformers have advocated limiting or even eliminating pretax retirement plan contributions in favor of Roth contributions," said Kathleen Coulombe, senior advisor for government relations at the Society for Human Resource Management (SHRM). "We've seen this notion of 'Rothification' floated," she said, "because removing the tax exclusion for 401(k) contributions would immediately generate billions of dollars," which could offset cuts in the corporate and individual tax rates.

For plan sponsors that currently do not offer Roth 401(k) provisions, "this might be a good time to consider putting those in their future plans," Credico recommended, "as we view these legislative conversations as 'leading indicators' of what might be to come in the future."

"As tax reform discussions continue to evolve, the SHRM-led Coalition to Protect Retirement will be engaged heavily in advocacy efforts on the tax treatment of employer-provided retirement benefits in the tax reform debate," Coulombe noted.

"The House bill contains two policy provisions that SHRM has advocated for several years," she added: allowing employees additional time to pay back defined contribution retirement plan loans should they be separated from employment unexpectedly, and improving the guidance related to nondiscrimination testing for defined benefit pension plans. These and other benefit provisions are explained below.


Hardship Withdrawals and Plan Loans

Under current 401(k) rules, hardship distributions are limited to the elective deferral amount not including earnings, and employees are prohibited from making new contributions for six months after receipt of a hardship distribution.

The tax bill "would allow employees to not only withdraw their own money but also to take the earnings on the money and potentially the company contributions," Credico said. "More importantly. employees who take hardship withdrawals would not be required to suspend their contributions to the plan, thereby allowing them to continue to get the company match and not have to remember to rejoin the plan when the suspension ends," she noted.

The bill also gives workers who leave the employer more time—until they file their income tax return—to repay a loan from their 401(k) plan.

"Collectively, these provisions will help people facing emergencies or financial challenges to put money they withdraw from their 401(k) plan, back into the plan and allow them to continue saving for retirement," Klein said.

 [SHRM members-only toolkit: Designing and Administering Defined Contribution Retirement Plans]


Penalty-Free and In-Service Distributions

The bill reduces from 62 to 59-½ the age at which workers may begin to receive defined benefit pension benefits even though they continue to work for the employer who sponsors the pension plan. "This change we have long-advocated will allow workers to reduce the hours they work and still collect their pension benefits, rather than forcing them to work for another employer or retire altogether," Klein said.

For 401(k) plans, the age to take money out without penalty is currently 59-½, but some state and local governments with 403(b) or 457 plans set the age at 62. The bill would declare the penalty-free distribution age as 59-½ for all of these defined contribution plans and well as for defined benefit pension plans.


Multiple Employer Plans

The bill would make it easier for unrelated employers to join together in a shared defined contribution multiple employer plan (MEP). Currently, employers participating in so-called "open MEPs" must file individual Form 5500s, which then requires individual plan audits for participating employers if their size so warrants. Also, the need for individual ERISA insurance would disappear under the legislation, if enacted.

"MEP adopters who currently have an annual audit requirement in connection with their Form 5500 filing (typically groups who have more than 100 eligible employees) will see a reduction in their annual plan audit fees of 90 percent or more. It's that dramatic," explained Terrance Power, CEO of the Platinum 401k Inc., a provider of outsourced retirement plan services.


Pension Nondiscrimination Testing

Defined benefit plans that are closed to new employees but that allow existing employees to continue to accrue benefits can, over time, run afoul of rules against discriminating in favor of highly compensated employees. "New Section 1506 would provide nondiscrimination testing relief to certain employers with closed defined benefit plans, provided they give new employees an increased benefit in a defined contribution plan," explained the American Society of Pension Professionals & Actuaries.


Education and Tuition Assistance

Employer groups responded negatively to the tax bill provisions that would affect employee education benefits. For instance, the bill would: 

  • Eliminate the Internal Revenue Code Section 127 tax exemption that allows employers to provide up to $5,250 of education assistance per year to their employees at the undergraduate, graduate or certificate level, tax-free.
  • Eliminate the Section 117 tax exemption for qualified tuition reduction programs that provide financial assistance for employees, their spouse or dependents at educational institutions. 

"Eliminating the tax treatment for employer-provided education assistance has consequences for employers and employees," Coulombe said. "Employers use this benefit to attract and retain talent, but also to retrain and reskill their employees to compete in an ever-changing global economy. If enacted, employees receiving this assistance will be penalized by being taxed on that benefit."

Annette Guarisco Fildes, president and CEO of the ERISA Industry Committee (ERIC) in Washington, D.C., which represents large employers, also expressed disappointment over these provisions. "A key deterrent to retirement security is mounting student loan debt that is hindering employees from saving for retirement," Fildes said. 

She called on congress "to assist employees in advancing education and paying off student loans, while still preparing for retirement." 

"The bill eliminates only the Section 127 qualified program that does not require the employee's educational expenses be work-related. Employers would still be able to offer the separate Section 132 working condition fringe tax-free educational benefit for work-related educational expenses," said Brian Gilmore, lead benefits counsel at ABD Insurance and Financial Services in San Mateo, Calif.

The Senate bill does not eliminate qualified education assistance program.  If the Senate passes its measure, both chambers will have to decide in a conference committee how to handle this and other differences.

Dependent Care FSAs

The tax bill as introduced in the House would have eliminated the tax exclusion for dependent care flexible spending accounts (dependent care FSAs). However, House Republicans amended their tax bill to remove that provision, although the favorable tax treatment for dependent care FSAs would sunset in 2022.

"The original version of the bill would have eliminated the dependent care FSA as of 2018. So this five-year delay is a small victory," said Gilmore. 

The elimination of dependent care FSAs is not in the Senate bill.

Left in place for the time-being are the current rules, under which parents can contribute to a dependent care FSA, on a pretax basis, up to $2,500 if the account holder is married and files a separate tax return, or $5,000 if the account holder is married and files a joint tax return or files as single/head of household.

Dependent Care FSA funds may be used for expenses relating to children under the age of 13 or incapable of self-care who live with the account holder more than half the year. Dependent care FSAs also can be used for a spouse or other qualifying dependent who is physically or mentally incapable of self-care and lives with the account holder, and for elder daycare when an elderly or disabled parent is considered a dependent and the account holder is covering more than 50 percent of the parent's maintenance costs.

Neither the House nor Senate bills would alter the tax treatment of funds contributed to a health FSA or to a limited-purpose FSA for dental and vision care.

Other Benefit Deductions

The bill also eliminates popular deductions for adoption benefits, relocation stipends and employee achievement awards. It would end the income exclusion for housing and meals provided to employees for the employer's convenience.

Employers would no longer be able to deduct expenses for qualified transportation benefits, but these benefits would remain nontaxable. "This means that employers will not be able to deduct any pretax transit and parking amounts, but they will remain tax advantaged for individual employees," explained the Employers Council on Flexible Compensation, a trade group.

Archer medical savings accounts (MSAs), a prototype version of health savings accounts (HSAs) with somewhat different rules, would no longer be tax advantaged but existing MSA funds could be rolled over, on a tax-free basis, to an HSA.

Executive Compensation

Regarding how executive pay is taxed, "there are extremely significant proposed changes" in the bill, explained John Lowell, a partner with October Three Consulting in Atlanta. The bill would:

  • Amend tax code Section 162(m)—which prohibits publicly held companies from deducting more than $1 million per year in compensation paid to senior executive officers—to eliminate the exemption for performance-based pay. "The exemption for performance-based compensation turned out to be a far bigger loophole than had been imagined" when section 162(m) was enacted in 1993, Lowell said. "Many companies saw this as a license to offer base pay of $1 million to their CEO while offering incentive pay—some only very loosely incentive-based—without limits while taking current deductions."
  • Expand the scope of covered individuals to include along, with an organization's CEO, the CFO and three highest paid employees.
  • Create a 20 percent excise tax for nonprofits—including 501(c)(3) and 501(c)(6) organizations—on the compensation of the five highest paid employees who earn more than $1 million.

A provision that would have replaced Section 409A on nonqualified deferred compensation (NQDC) with a new Section 409B was struck from the bill. "Essentially, 409B as drafted would have applied the much more stringent taxation upon vesting rules that have previously applied generally only to 457(f) plans," Lowell noted.

Altering  the tax treatment of NQDC plans would have resulted in "making them less advantageous, as new monies put into these plans would become taxable once the money becomes vested," Credico said. 


Altered Tax Rates

The GOP tax plan would:

  • Reduce the corporate tax rate from 35 percent to 20 percent.
  • Nearly double the standard deduction—the amount of money not subject to federal income tax—from $12,700 per family to $24,000.
  • Raise the child tax credit to $1,600 from $1,000 but repeal the $4,050 per child exemption.
  • Repeal the Alternative Minimum Tax.
  • Eliminate the estate tax as of 2024.

The level of earned income that is subject to federal income taxes can influence a number of employee decisions, such as the level of tax withholding they request from their paychecks; how much salary they defer into a traditional 401(k) plan, which reduces taxable income for a given year; and whether to participate in a nonqualified deferred income plan, if that option is available through their employer.

Other Scrapped Deductions

The tax bill would get rid of many popular deductions, a move that interest groups and lobbyists have vowed to fight. Among the targeted deductions, the bill seeks to:

  • Reduce the cap on the deduction to interest on mortgages to $500,000 for newly purchased homes. The current cap is $1 million. Mortgage interest for vacation homes no longer would be deductible.
  • Limit the deductibility of local property taxes to $10,000 while eliminating the deduction for state income taxes.
  • Eliminate the deductibility of student loan interest.
  • End the medical deduction available to taxpayers whose medical expenses are above 10 percent of their adjusted gross income.

Monitoring Developments

The legislation is the first major revamp of the U.S. tax code in three decades and has been a top Republican priority.

"While no tax bill in my lifetime or likely anyone else's lifetime has made it through the legislative process unscathed, the draft bill fashioned as HR 1 certainly provides an indicator of where we may be headed," said Lowell.

"There’s no telling when or if the tax bill will pass, let alone what provisions might survive as part of a final package, so we expect many employers will proceed with their current benefit offerings," said Scott Behrens, senior benefits attorney with Lockton Compliance Services in Kansas City, Mo. However, "employers might need to move quickly to adapt to any finalized tax law changes."

Related SHRM Article:

Senate Tax Bill Altered to Kill the ACA's Individual Mandate, SHRM Online Benefits, November 2017


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