Are Retirement Saving Incentives Incompatible With Tax Reform?

Anyone whose job requires tracking and evaluating legislation, may—sooner or later—consider the benefits of counseling, anti-depressants, or both.  It can be genuinely depressing to witness the developments, or more accurately the lack thereof, on Capitol Hill.  It is depressing on the one hand to witness the lack of cooperation and compromise among senators and representatives whose job it is to govern.  But it is similarly troubling to repeatedly hear from certain sectors that maintaining important Tax Code benefits—like retirement saving incentives—is incompatible with solving our nation’s budget problems, and putting our nation’s fiscal ship on a safe and sustainable course. 

We believe firmly that using tax benefits to encourage people to save for retirement and addressing the federal budget issues are not incompatible goals.   A closer look at the real nature of retirement saving incentives will show how much they differ from some of the other popular “perks” and “tax costs” contained in the Tax Code.  If lawmakers consider just ONE very singular difference, it should be a slam-dunk to maintain retirement saving incentives.  The question is whether lawmakers will take the time to really understand how they differ from other Tax Code incentives, some of which actually do result in lost federal tax revenues.

A close look at this issue is important because the nation seems headed in the direction of tax reform, later if not sooner.  There are multiple tax reform options that have been proposed, most of which—to varying degrees—could significantly restrict or revamp current retirement saving options.  One proposal is to sweep away all tax deductions and exclusions in favor of reduced tax rates, perhaps adding back the most critically important tax incentives.  Another would limit the maximum retirement saving accumulations in combined IRAs and employer plans, while yet another would reduce and cap annual tax deferrals and exclusions.  And there are more, all having the effect of limiting retirement saving tax benefits.

Most of these reform strategies are being proposed under the assumption that workers’ earnings that are deferred or excluded from income each year through retirement saving are lost to the federal revenue stream, and thereby are a “cost” in the grand federal budget-balancing equation.  

This is simply untrue, and a comparison with several other popular—and worthy—Tax Code incentives will demonstrate why.  Consider the universally popular home mortgage interest deduction, which all of us who have purchased a home have benefited from.  By deducting from our taxable income the interest portion of our home mortgage payments, we reduce our tax obligation.  But, in the bargain, the collection of federal tax revenues is reduced, permanently.  Is it a benefit to society to promote home ownership?  Certainly, both for tangible reasons of stimulating the economy, and the intangibles of neighborhood and broader social stability.  But make no mistake, the nation as a whole “pays” for this tax perk.

The same is true of charitable giving, as noble and as beneficial to society as sharing our resources with others may be.  Charitable giving deductions, like the home mortgage interest deduction, reduce taxable income, and thereby permanently reduce the federal tax revenues that such generous taxpayers would otherwise have contributed to the federal tax coffers.  I am not advocating taking away these very beneficial tax incentives that most would say provide a very useful and valuable social benefit but rather using them by way of comparison to the incentives provided for retirement savings. 

Consider, now, the deductions and exclusions for IRA or employer plan saving.  With the exception of Roth-type accounts, every dollar that is given a tax benefit in the year it is contributed to such a plan or account is taxed when it is withdrawn, either during the saver’s retirement years, or by a beneficiary.  Not only are such dollars taxed, but—in being spent by retirees or beneficiaries—they provide dollar-for-dollar stimulus to the economy. 

Furthermore, the assumption of some policy makers that such dollars will be taxed at a lower rate in the withdrawal years is not necessarily sound.  Many taxpayers with substantial retirement savings are NOT in lower taxing brackets after retirement, and beneficiaries—often younger and in their peak earning years—are unlikely to be in the lowest taxing brackets.

So, it cannot logically be argued that retirement saving represents a permanent loss to the nation’s budgetary process.  Therefore, it cannot logically and honestly be argued that tax reform and retirement saving are incompatible.  It is my fervent hope that Congress recognizes this before it throws the retirement saving “baby” out with the tax reform “bath water!”

DOMA Ruling Will Complicate Retirement Plan Compliance

 

Whatever your political or religious views on same-sex marriage, there is little doubt about one consequence of the Supreme Court ruling in United States v. Windsor. There will be significant complication in the administration of retirement plans, at least in the near term. The border-to-border consistency that DOMA provided in spouse-related retirement plan and other benefit plan rules is essentially gone now.   

 

The key element of the Supreme Court’s Windsor ruling is its conclusion that federal law—including those elements that pertain to retirement plans—must recognize same-sex spouses that are legally married under state law. This sounds straightforward, but—as we will see—it’s not that simple.  

 

Following are some of the effects of the DOMA decision in situations where same-sex partners are recognized as married. Bear in mind, the effects may be different in states that do not recognize these marriages. 

  

• The same-sex spouse of a participant in an ERISA-governed plan will have to be given primary beneficiary status unless they affirmatively waive this right.
• Spouse beneficiary options to treat an ERISA-governed plan account as their own, possibly for rollover to their own IRA or to another employer plan, must be honored.
•  In employer plans subject to the Retirement Equity Act (money purchase, defined benefit, and some profit sharing plans), a spouse will have to consent to any distribution that is not in the form of an annuity, and—as a surviving beneficiary—must waive receiving benefits in the form of an annuity.
• For IRAs administered in community or marital property states, a same-sex spouse would likely have to waive their right to be a primary beneficiary if he or she were to be excluded.

  

Some significant uncertainties remain after this decision. Most of these are a consequence of the fact that Windsor did not invalidate the DOMA provision that allows states to recognize only marriages valid under their own laws and disregard marriages that are valid under the laws of another state. The practical aspect of this leaves one with questions like how will the plan of a company based in a state not recognizing same-sex marriage treat an employee who is considered married under the laws of another state? Will a participant who moves from a state that recognizes same-sex marriage to a state that does not recognize the marriage acquire a different marital status for plan purposes? Could a plan, for the sake of uniformity and simplicity, be able to choose to recognize all legally married same-sex relationships, even if the state of domicile of the sponsoring business does not allow same-sex marriage, and does not recognize same-sex marriages performed elsewhere?

  

A number of plan operations and determinations will be affected, though to what extent may depend on further guidance. For instance, hardship distribution availability can be determined by spouse status; the required minimum distribution (RMD) rules are more flexible, both before and after participant death, with a spouse beneficiary; knowing the status of an individual as a spouse—or not—is vital in QDRO determinations; plan testing requires identification of HCEs, which can be influenced by the ownership attribution rules that apply to spouses. Needless to say, the reach and impact of the Supreme Court decision are only beginning to be understood. Another potential area of impact may be plan documents. If a plan has a DOMA based definition of spouse in the document, it will likely have to be amended. Will there be a reasonable remedial amendment period during which plans can make any changes to their governing documents that might be necessitated by the Windsor decision? We have to believe fairness will dictate that this be offered. 

 

Yet another issue relates to the terms domestic partnerships and civil unions? Will the word “marriage” in the Supreme Court’s Windsor ruling be pivotal in federal treatment of same-sex couples who are in state-recognized relationships that are substantially like marriages, but are not actually called marriages?  

 

In the IRA realm, consider an IRA document that states that the laws of the sponsoring financial organization’s headquarters state will be controlling if a dispute arises over rights or options. What will be the consequences if the IRA owner’s state law definition of marriage covers same-sex marriage, but the state where the financial organization is based does not?  

 

Beyond these and other unanswered questions that Windsor has left us, it’s highly likely that we will see more litigation on same-sex marital rights. Already, another case is brewing in Nevada that could go to the heart of whether the U.S. Constitution is violated if states dictate who their citizens may marry. We will likely also see more state legislation and constitutional actions, either to affirm, or to deny, same-sex marriage rights, as activists on both sides see urgency and opportunity.  

  

Hold on, for what may be a long and bumpy ride.