We’re getting a lot of questions these days about how the proposed tax reform bills might impact retirement plans. For reference, this Forbes article provides a good summary and comparison of current law versus the House and Senate bills.
Here are the two questions that we’re getting most frequently:
Will the tax reform bills impact how much I can contribute to my retirement plan?
The short answer here is “probably not”. Although the potential of lowering the salary deferral limit in 401(k) plans from the current $18,000 ($18,500 in 2018) was bandied about originally, the idea was met with strong resistance. Neither the currently proposed House or Senate bill would lower this limit, and neither would impact the employer contributions that could be made to any type of retirement plan (401k, defined benefit, cash balance, etc.).
If I can pay a low tax rate now, does it make sense for me to set up a retirement plan?
This is a much meatier question. For most of our business-owner clients, the primary motivation for setting up a retirement plan is to defer paying taxes on income.
To the extent that your income tax rate in retirement is expected to be less than or equal to your current rate, the answer is clear: Deferring taxes on retirement plan contributions provides a significant advantage in long-term wealth accumulation. Barring significant tax reform, this is a pretty safe bet: Your lower income in retirement will almost certainly put you in a lower tax bracket than you’re currently in.
However, if your income tax rate in retirement is expected to be significantly higher than your current rate, the advantage of deferring taxes now is lessened or eliminated. Is this a possibility?
This question has mostly come up in the context of proposed pass-through business income tax rates. As background, subchapter S corporations (S corps) don’t pay tax at the business level; instead, income of the business is allocated among the owners, who pay the corresponding tax on their individual returns. Under current law, there isn’t a significant difference tax-wise between an S corp owner taking W-2 wages or taking business profits as pass-through income (although payroll and Social Security taxes are not paid on pass-through income).
What’s been grabbing headlines lately is the claim that the House and Senate bills will reduce the pass-through income tax rate to 25%. On the face of it, this would provide a significant incentive for S corp owners to lower their W-2 wages, take more income as pass-through, and pay the low 25% rate. However, there are some significant caveats here:
- In both bills, owners of service businesses would generally not benefit from these changes to the pass-through rates (in the Senate bill, service business owners could potentially benefit, but only if their income is very low). The bills don’t define “service businesses” carefully, but it’s generally understood to be any business where the primary output is a service, and not a material good (e.g. – doctor offices, law firms, accounting firms, etc.).
- In the House bill, only passive income would be subject to the 25% pass-through rate. Earned income would still be subject to the individual’s income tax rate.
In short, the proposed tax bills might provide some individuals the opportunity to pay income taxes at a lower rate, but perhaps not as low as the headlines suggest. As always, you should consult with a qualified tax advisor to determine whether taking significant tax deductions makes sense for you and your business. And if you decide that it does make sense, contact us to see what would be possible with a new retirement plan.