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Benefit plan sponsors seek to protect—even expand—favorable tax treatment
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Update: Congress Passes Tax Cuts and Jobs Act
On Dec. 20, 2017, Congress passed the Tax Cuts and Jobs Act. See these SHRM Online articles:
Congress Passes Tax Bill Altering Employee Benefits
Tax Bill Will Alter Executive Pay and Bonus Decisions
What the Individual Mandate Repeal Means for Employers
Republican framework for tax reform that the White House unveiled last week does not propose specific changes to how employer-sponsored benefit plans are taxed, but that doesn't mean Congress won't choose to do so when it crafts legislation.
"I don't believe that it's safe to say the deductions for workplace benefit plans have been spared just because the tax outline doesn't specifically say they'll be cut," observed Kathleen Coulombe, senior advisor for government relations at the Society for Human Resource Management (SHRM). "There are concerns that employee benefits could be targeted later in the process as the need to generate greater revenue to offset tax cuts becomes critical."
While eliminating current deductions to offset lower tax rates could prove tempting to Congress, there also may be opportunities to improve the tax treatment of some employee benefits, plan sponsors and their advocates said.
Under the current tax code, salary-deducted payments for group health plan premiums are excluded from an employee's gross income, while employers can deduct premiums they pay as a business expense. In 2018, these exclusions and deductions will lower tax revenues by $235.8 billion, the U.S. Treasury Department estimates.
"We've been long concerned, not without justification, that Congress would eye the current tax-free nature of employer-provided health insurance as an easy way to raise revenue to pay for other tax cuts," said Edward Fensholt, senior vice president and director of compliance services at Lockton, a benefits brokerage and consultancy based in Kansas City, Mo.
As Congress considers tax reform proposals, SHRM is "urging lawmakers to avoid any future changes to the tax treatment of employer-sponsored health coverage," said Chatrane Birbal, SHRM senior advisor, government relations.
One change, however, that SHRM and plan sponsors would like to see is the long-sought repeal of the Affordable Care Act's "Cadillac tax"—a 40 percent excise tax on employer-sponsored health coverage above certain benefit thresholds ($10,200 for individual coverage and $27,500 for family coverage), set to start in 2020.
"As the costs of health insurance continue to rise, the impending Cadillac tax continues to threaten employers and their employees with higher health benefits costs," said Birbal.
If Congress doesn't take action and the tax goes into effect, "many employers will be subject to the 40 percent excise tax, including 33 percent of SHRM members' organizations," she noted.
While supporting Cadillac tax repeal, Katy Spangler, senior vice president for health policy at the American Benefits Council in Washington, D.C., cautioned against replacing the levy with a cap on the tax exclusion for employer-sponsored coverage, an idea that some tax reformers have supported in the past.
"Instead of eroding employer coverage, we should strengthen it by expanding health savings accounts and supporting efforts to make preventive care more affordable," Spangler said.
Currently, employer contributions to traditional 401(k) and similar retirement plans are deductible and employees' payroll-deferral contributions are made with pretax dollars under Section 125 of the tax code. Distributions from the plan to provide retirement income are then taxed.
The Treasury Department estimates that the tax advantages that traditional defined contribution plans receive will lower tax revenues in 2018 by $69.4 billion. This estimate doesn't take into account future tax revenues that will be generated when retirement plan funds are eventually withdrawn, those defending the current tax exclusion point out.
Employee contributions to a Roth 401(k), in contrast, are made with post-tax dollars, while distributions during retirement are tax-free.
"Some tax reformers have advocated limiting or even eliminating pretax retirement plan contributions in favor of Roth contributions," Coulombe said. " We've seen this notion of 'Rothification' floated before, because removing the tax exclusion for 401(k) contributions would immediately generate billions of dollars, and they're going to need to offset cuts in the corporate and individual tax rates."
Some tax reformers advocate limiting the tax exclusion for 401(k) contributions.
Lynn Dudley, senior vice president for global retirement and compensation policy at the American Benefits Council, also expressed concern that retirement plan benefits could be vulnerable.
"We should be wary of so-called 'Rothification' efforts that would change some or all retirement savings from a pretax benefit to an after-tax contribution," Dudley said. "Not only is this short-sighted—effectively forgoing future revenue to pay for present-day spending—it is also a dangerous experiment that could have seriously negative effects on individuals' savings behavior."
"Because [Roth] accounts are after-tax they produce revenue in the present tax year as opposed to tax deductible and deferred retirement accounts which decrease tax revenue in the present," explained Sarah Brenner, J.D., an analyst with financial advisory firm Ed Slott and Co. in Philadelphia, in a recent blog post. "Of course, down the road, something politicians don't like to dwell on, Roth accounts are revenue losers with the tax-free earnings they produce."
Moreover, "there are concerns that many simply would not make contributions without the incentive of an immediate tax break," Brenner noted. "Despite being around almost 20 years and offering big tax benefits, statistics show that Roth accounts are still the minority of retirement accounts. People like the immediate benefit of a tax break in the year a contribution is made."
Despite the opposition, "Rothification remains a very real possibility," the Groom Law Group in Washington, D.C., said in an analysis of the tax outline. "Congress will likely have very few options to raise the revenue necessary to offset the cost of rate cuts, and Rothification may be one of the least controversial."
"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 said.
[SHRM members-only toolkit: Designing and Managing Flexible Benefits (Cafeteria) Plans]
The tax reform framework includes a proposal to lower the tax rate on small business "pass-through" income to 25 percent, which could inadvertently lower the incentive for small businesses to provide employee retirement plans, according to Craig Hoffman, general counsel for the Arlington, Va.-based American Retirement Association, which represents retirement plan sponsors and advisors.
"Many of these businesses may reconsider adopting or maintaining a qualified retirement plan" if the proposal is enacted, Hoffman wrote in a blog post. These disincentives arise because of the difference between the 25 percent maximum pass-through rate and the 35 percent top rate on ordinary income, he noted. "The owner of a 'pass-through' business is likely to pay far less in taxes if amounts are passed-through and taxed at the 25 percent rate rather than contributed to a qualified plan."
A simple technical correction, he advised, would be for the legislation to provide that the business owner's contribution amount "will flow through and be taken as a deduction against the wage or personal services income that would otherwise be taxed at ordinary individual income tax rates. In this way, the tax treatment would be consistent when contributed and deducted."
The GOP framework, under a section headed "Work, Education and Retirement," states that congressional committees "are encouraged to simplify these benefits to improve their efficiency and effectiveness."
"That wording makes us nervous," Coulombe said, as there are concerns that simplification could negatively affect the tax exclusion not just for employer-sponsored retirement plans but for tuition assistance and other workplace benefits as well.
Section 127 of the tax code currently allows an employee to exclude from taxable income up to $5,250 per year in employer-provided educational assistance—an amount that has never been raised and is not indexed to inflation. "Many employers and stakeholders feel that this amount should be increased," Coulombe said.
SHRM also supports the bipartisan Employer Participation in Student Loan Assistance Act, now before Congress, which would amend Section 127 to allow employers to provide student loan repayment assistance with pretax dollars.
Expanding Section 127 to include student loan repayments "would assist employers in attracting employees—many of whom are Millennials—to their workplace," Coulombe said.
A change to the child tax credit could have an adverse impact on dependent-care assistance flexible spending accounts (FSAs), said Bill Sweetnam, legislative and technical director at the Employers Council on Flexible Compensation (ECFC) in Washington, D.C., which represents sponsors of account-based benefit plans.
Tax rules require that the benefits provided under a dependent care FSA not discriminate in favor of highly compensated employees, but "recognizing that the child tax credit may be a better fit for lower-paid workers, employees whose compensation is less than $25,000 are not counted when conducting this nondiscrimination test," Sweetnam explained.
ECFC has asked that if changes are made to the child care credit that allow individual with higher incomes to take advantage of the credit, that the nondiscrimination rules for dependent care FSAs be modified so that employees with higher compensation levels are disregarded in nondiscrimination testing. "If that doesn't happen, employers may not offer dependent care FSA plans since they may not be able to meet the nondiscrimination testing requirements," he said.
ECFC also asked that the maximum amount that can be contributed to a dependent care FSA be increased from the current $5,000, which is not indexed for inflation. "If the tax code is to be changed to help families, dependent care FSAs should be part of the mix as well as the child care credit," Sweetnam said.
Sweetnam is also concerned that "in an attempt to raise tax revenues to offset some of the contemplated tax changes, the current tax benefits for commuter benefits may be cut back or eliminated."
The favorable tax treatment of commuter benefits "doesn't just help employees by incenting them to use public transportation, but it also reduces the costs to government for transportation infrastructure as more people rely on public transportation," he said.
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