Taxing Deferred Compensation Benefits-A Balancing Act

Friday, March 01, 2013

Within The Revenue Act of 1978 was an obscure section of the law which included a provision that has become known as Internal Revenue Code (IRC) Sec. 401(k), which obviously became the basis for most private sector employer’s sponsored, deferred compensation retirement plans in existence today. The Act formalized provisions allowing the use of pre-tax employee salary reductions as a source of plan contributions. Since that time, 401(k) and similar plans have found their way into government, health care, educational, and non-profit employers in the US and in many foreign counties. Generically known as deferred compensation or “DC” plans, benefits are based on employer and employee contributions plus investment gains/losses. Although often referred to as savings and profit sharing plans, they are a major component of the retirement plan space. The key to the employer popularity of 401(k) like plans is due to their simplicity and low relative cost for employers to operate. For employees it’s the availability of pre-tax contributions, self-directed controls, and portability.

Over the last 30 years, the aggregate accrued balances of US held 401(k) plans have grown to $3.5 trillion as of the 3rd quarter of 2012 according to Investment Company Institute. In recent days those balances have come under a closer review as the nation attempts to management its need for revenue in efforts to balance the budget. If those balances had accrued on a post-tax basis, similar to the Roth 401(k) after tax plans, the US government would have collected billions in additional tax revenue. It is not that this revenue is lost; it is merely differed until monies are withdrawn either during retirement or at some other time.

The Brookings Institution released a study on “15 Ways to Rethink the Federal Budget”, number 6 is titled “Better Ways to Promote Saving through the Tax System” authored by Karen Dynan, vice president, co-director of the Economic Studies program, and the Robert S. Kerr Senior Fellow at the Brookings Institution. Dylan proposes to, “Cap the rate at which deductions and exclusions related to retirement saving reduce a taxpayer’s income tax liability at 28 percent.” This, she believes, “would reduce the benefit associated with contributions to … the higher-income tax payers …”

In response to Dylan’s proposal, Brian Graff, Executive Director/CEO of The American Society of Pension Professionals & Actuaries (ASPPA) stated. “Because the tax incentive for retirement savings is a deferral, not a permanent exclusion, the proposal would more accurately be described as double taxation of contributions to retirement savings plans for anyone with a marginal tax rate of over 28%.” Graff’s concern is that if business owners are penalized, they will be less likely to implement and/or maintain 401(K) plans for their employees. Expanding 401(k) access is one of Dylan’s additional proposals as a means to boost employee savings.

401(k) plans are especially attractive to new and small businesses due to their relative low cost of implementation and ongoing operations and attractiveness to employees. Other forms of employee retirement plans are not only more costly, but are significantly more complex to operate and communicate to employees. 401(k) plans are often the only cost and administrative practicable means of providing retirements benefits for small and medium sized businesses. The curtailment of such means could hamper a small business owner’s ability to compete for and attract, retain, and motivate the top talent and skilled workforce required for it to survive and grow.