The tax reform bill that went into effect on January 1, 2018 has gotten a lot of attention lately. Everyone wants to know how it will affect them and whether or not it will benefit their bottom line. Plan sponsors and business owners are probably wondering the same thing. Is the tax bill bad for tax-qualified retirement plans? We don’t think so.
What Does The New Tax Law Change For Businesses?
First of all, the new tax law won’t change any of the contribution limits for 401(k) plans. That’s a good thing, considering there were reports that limits might be lowered to help offset the tax cuts. However, all 401(k) limits remain intact and business owners’ retirement plan contributions will not be lowered.
Next, there is a new 29.6% marginal tax rate for some pass-through businesses like S-corporations. That rate is comprised of a 37% tax rate with a 20% discount. That doesn’t apply to all pass-through companies though. The law lists specific types of companies that are ineligible for the discount, which we will discuss below.
Finally, C-corporations have a new 21% tax rate, but their dividends are subject to additional tax when they take out their profits. To avoid this double taxation, many small C-corporations pay their owners a salary through a W-2. In this circumstance, that money is still subject to individual income tax rates, with the new top rate set at 37%.
How Do The Changes Affect Plan Sponsorship?
No matter the tax rates, qualified retirement plans still offer the benefit of tax-deferred growth. Even when you invest money that would have been taxed at 29.6% and face a 37% tax at withdrawal it is still beneficial, as you’ll see below.
Of course, retirement plans are more attractive when tax rates are the same pre- and post-retirement, so there is some reduced incentive for some pass-through entities. For many pass-throughs and C-corporations, however, the new tax law makes only a negligible difference. Let’s take a look at what that means with some real numbers.
An Example Of The Effects
For our example, we will use a company where the owners are in the highest tax bracket, which was 39.6% for 2017. They are considering a $50,000 employer contribution to their plan where they would leave it to grow at 7% for 20 years. Assuming a 39.6% tax rate at retirement, would that be a wise move? Yes, it would. Sponsoring a retirement plan would save them $34,319.13 due to tax-deferred growth under the old rules.
Now, let’s see how that same scenario will play out in 2018 under the new tax law.
1. For a C-Corporation
If they have a small C-corporation, they would be taxed at 41% if they distributed their profits through dividends. A 21% tax on all profits and a 20% tax on dividends results in a 41% tax rate. If they take their profits out through a W-2 as many do, the new tax law will have negligible effects. Their total tax savings become $33,466.17 due to marginal rates dropping from 39.6% to 37%.
2. On A Professional Pass-Through Business
What if their company is a pass-through that provides professional services like doctors, lawyers, or dentists? (Under the new law, engineering and architecture firms are not included in this example and would be subject to our third example.) For these firms, the effect will be negligible as well. Their total tax savings also become $33,466.17 due to the marginal rate transition from 39.6% to 37%. Some in this category will have a slightly different result since income under $315,000 is in a 29.6% tax bracket.
3. On Other Pass-Throughs
The real difference happens when a firm is a pass-through company that manufactures something or has large capital requirements to run the business (or if they have an engineering or architectural firm). These firms have a reduced incentive to sponsor a retirement plan, because they get to deduct 20% of their taxable income, making their tax rate 29.6% on business profits. However, in spite of that, their total tax savings would still be $23,056.94. Clearly, there is still a powerful tax incentive to sponsor and contribute to a retirement plan, even though it may be slightly reduced in some cases.
Overall, the new tax bill does not remove the advantage of retirement plans for business owners. In fact, the tax deduction on 401(k) contributions is even more powerful for employees now because they can still get it while using the new larger standard deduction. Sponsoring a retirement plan is still a smart move under the new tax plan. If you are considering sponsoring a plan for your business and want to know what kind of tax savings you would get, call our office today.
The Farmer & Betts team offers the highest level of expertise and service, as well as an ERISA attorney on staff and an experienced compliance department. We are happy to support you with specialized plan design and competitive fees. Contact us by email or by phone at 503.885.0505 to learn more.