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Retirement Perspectives

Both the House and Senate versions would protect popular pretax savings strategies. 

On November 2, House Republicans released their much anticipated tax reform plan, which they named the “Tax Cuts and Job Act.” If the bill passes, it would be the first major U.S. tax reform in more than 30 years. While the 420-page bill offers a number of reforms, this column will discuss the provisions that could affect qualified retirement plans, IRAs, and 529 accounts.

Interestingly, IRAs were left mostly untouched. Notably, “stretch” IRA payout and “back door” Roth accounts would remain viable strategies, despite numerous reports of repeal.

As a supplementary document released with the bill explained: “The Tax Cuts and Jobs Act makes no changes to the popular retirement savings options that Americans have today, including 401(k)s and Individual Retirement Accounts, or IRAs. Americans will be able to continuing making both traditional, pretax contributions and ‘Roth’ contributions in the way that works best for them.”

With that announcement, 401(k) investors should breathe a sigh of relief, because overall deferral limits  would be unaffected; rather, participants will continue to have the option of deferring income on a pretax basis, Roth, or combination thereof. Prior to the release, there was considerable discussion of capping or eliminating pretax deferrals to help “pay for” other reforms included in the bill.

“This is obviously great news,” said Brian Graff, CEO of the American Retirement Association, in response to the news that pretax deferral limits will be retained, “but we need to keep the pressure on [representatives] because we know that things can change, and we certainly can’t afford to take things for granted.”

Below is a summary of the provisions affecting retirement accounts as it stands today.

Recharacterization
An unexpected provision was the announcement that the rules permitting recharacterizations of both Roth contributions and Roth conversions would be repealed in tax years beginning after December 31, 2017. The elimination of the Roth recharacterization would effectively make Roth conversion permanent.

Moreover, those taxpayers that make new Roth contributions would have to be cautious: under the current proposal, their Roth contribution amount could not be recharacterized to a traditional IRA if he/she loses their eligibility as a result of exceeding annual Roth income limits. In that scenario, it seems an investor would be then required to withdraw the contribution plus earnings as an excess contribution 

Interestingly, the rules allowing the Archer Medical Savings Accounts (MSAs) would be repealed, given that they have been replaced by health savings accounts (HSAs). Notably existing MSA funds would be transferrable into an HSA.

Hardship Distributions
The proposal repeals the six-month suspension on 401(k) salary deferrals following a hardship distribution. In addition, the proposal would expand hardship funding sources to include both employee and employer contributions and any associated earnings. Current hardship rules allow the distribution only of employee deferrals (not including earnings). 

Also, some plans currently require a participant to take a plan loan before qualifying for a hardship distribution; under proposed legislation, a distribution would not fail to qualify as a hardship solely because it was taken prior to a loan.

Loans
A terminated participant with an outstanding plan loan generally has 60 days to pay off the outstanding balance in order to avoid paying income taxes and penalties on the outstanding amount. However, the proposal gives a participant additional time to roll over an outstanding loan into an IRA, thus extending the repayment deadline from the traditional 60 days to an investor’s tax-filing deadline (including extensions) and so avoid paying taxes and penalties.

In-Service Distributions
Participants in qualified retirement plans are not permitted to take distributions from the plans while employed, unless the participant reaches age 62, with regard to defined benefit (DB) plans and governmental defined contribution (DC) plans or age 59½ for DC plans. The proposed legislation would eliminate the disparity, thus allowing DB plan participants to receive a distribution of benefits upon attaining age 59½. Notably, this provision would also apply to participants in governmental 457(b) plans.

(Click here for our last article on in-service distribution rules.)  

529 Plans
A provision that few anticipated is the ending of Coverdell Education Savings Accounts. In other words, ESAs that currently exist could remain, but no new contributions would be permitted after the end of 2017. In addition, the proposal allows ESAs funds to be rolled into 529 accounts.

Most investors funded ESAs due to the allowance of tax-free distributions to pay for K–12 educations. The proposal, beginning in 2018, would place 529 college savings plans on equal footing, thus allowing up to $10,000 a year to pay for K–12 expenses. Also, unlike Coverdell accounts, 529s do not impose income limits to contribute.
 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

A 403(b) plan is a retirement savings plan that allows employees of public schools, nonprofit, and 501(c)(3) tax-exempt organizations to invest on a pretax and or Roth aftertax basis. Contributions to a 403(b) plan are conveniently deducted directly from your paycheck. In addition, your employer may elect to make a contribution on your behalf.

457(b) is a nonqualified, deferred-compensation plan established by state and local governments, tax-exempt governments, and tax-exempt employers. Eligible employees are allowed to make salary deferral contributions to the 457 plan. Earnings grow on a tax-deferred basis and contributions are not taxed until the assets are distributed from the plan.

A Coverdell Education Savings Account (ESA), formerly known as an Education IRA, is an attractive tax-advantaged college saving vehicle that allows an investor to save and pay for higher education for the account beneficiary (typically a child).

529 plan is a tax-advantaged investment vehicle in the United States designed to encourage saving for the future higher education expenses of a designated beneficiary.

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