Qualified Plans at Risk When Jumbled with True Tax Expenditures

January 24, 2013

Authored by: benefitsbclp

This is the first post in a three part series where we’ll focus on the impact that upcoming “tax reform” and the “second fiscal cliff” negotiations might have on qualified retirement plans, particularly on 401(k) plans.  The impetus for writing this series is not the political rhetoric emanating from Washington nor is it something already proposed like the report of the Simpson-Bowles Commission.  Rather, the impetus is the recent paper issued by the United States Government Accountability Office (the “GAO”) entitled Tax Expenditures: Background and Evaluation Criteria and Questions (the “GAO Paper”).

The GAO does not identify any particular “tax expenditure” in the GAO Paper.  Rather, the GAO paper is intended to assist Congress in understanding the effectiveness of tax expenditures as it embarks on its effort to revise the Internal Revenue Code (the “Code”).

The GAO describes tax expenditures as “reductions in a taxpayer’s tax liability that are the result of special exemptions and exclusions from taxation, deduction, credits, deferrals of tax liability, or preferential tax rates.”  This quote comes from James R. White, Director, Strategic Issues, GAO in a letter dated November 29, 2012 to The Honorable John Lewis, Ranking Member, Committee on Ways and Means, Subcommittee on Oversight, United States House of Representatives (“White Letter”).  The White Letter is a cover letter for the GAO report.  The GAO further states in the White Letter that an estimated $1 trillion in revenue was foregone from the 173 tax expenditures reported for fiscal year 2011.  Interestingly, this is approximately the amount of the annual budget shortfall (deficit) for 2011.

In the White Letter, the GAO states that it considers tax expenditures to be tax provisions that are exceptions to the “normal structure” of individual and corporate income and other taxes necessary to collect federal revenue.  Tax expenditures, according the White Letter, can have the same effect as government spending programs.  And here is where the retirement community must diverge.  A spending program means the money has left the government for uses that do not cause the “spent” funds to be returned to the federal fisc.  It is gone, hopefully, to support some proper public purpose.

The “tax expenditures,” if we wish to call them that, inherent in the retirement system do come back to the federal fisc since they are taxed later.  In other words, the tax implications for the retirement system do not have the same effect as a government spending program.  That is the case if one understands the meaning of deferral.  Congress apparently does not.  Congress passes budgets based on the short term and does not take all of the deferred retirement plan income into account when doing so.  Congress passed the Congressional Budget and Impoundment Act of 1974 requiring that it not consider income and expense beyond a five year period of time, effectively causing the process to ignore the bulk of deferred income that will come from tax-qualified retirement plans.  Most deferrals for retirement extend out far longer than five years, and, therefore, the taxes they will generate are mostly overlooked in the budget process.  The timing mechanism used to “net” the amount of the expenditure is surely flawed as retirement savings are intended to follow a long-term horizon.  And, of course, in the long-term, tax rates, market conditions and many other factors will influence the amount of funds returned to the federal fisc.

Congress established a system of deferred compensation through defined contribution and defined benefit plans of many types to assist Americans with the prospect of retirement with dignity.  However, that system may be at risk when Congress fails or refuses to recognize that the retirement plan “tax expenditure” is unlike most, if not all, others.

The GAO Report identifies six types of tax expenditures that are exceptions to the “normal tax structure”:  exclusion, exemption, deduction, credit, preferential tax rate, and deferral.  The retirement system avails itself primarily of exclusions (like a 401(k) elective deferral), deductions (the amount the employer deducts when employer and employee contributions are made to a qualified plan), and deferral (the redundancy is palatable with retirement plans since it is the exclusion and deduction that create a tax benefit and the deferral results in income recognition – in other words, it eviscerates the tax expenditures over time).  In fairness to the GAO, the GAO Report’s example of a deferral is the payment of interest on U.S. savings bonds at redemption, a situation that is a pure deferral.  And in further deference to the GAO, the GAO Report makes it clear that it is Treasury that classifies contributions to, and earnings on, retirement plans as tax expenditures.  The GAO report states that these contributions and earnings would not be considered tax expenditures under a consumption tax system.
The Joint Committee on Taxation has prepared a document for consideration by the Senate Finance Committee describing the tax expenditure that exists for qualified plans (see, Background Information On Tax Expenditure Analysis And Historical Survey Of Tax Expenditure Estimates, JCX 15-11).  The description does indicate that some “income” component is considered in order to net the amount of the expenditure:

Under normal income tax law, employer contributions to pension plans and income earned on pension assets generally would be taxable to employees as the contributions are made and as the income is earned, and employees would not receive any deduction or exclusion for their pension contributions. Under present law, employer contributions to qualified pension plans and employee contributions made at the election of the employee through salary reduction are not taxed until distributed to the employee, and income earned on pension assets is not taxed until distributed. The tax expenditure for “net exclusion of pension contributions and earnings” is computed as the income taxes forgone on current tax-excluded pension contributions and earnings less the income taxes paid on current pension distributions (including the 10-percent additional tax paid on early withdrawals from pension plans).

However, with a five year limitation for budgeting purposes, the full impact of the deferred tax is not realized.  This should cause Congress to view the retirement plan expenditure differently from a spending tax expenditure where no income is directly returned to the federal fisc in exchange for a current tax benefit.

Generally, the tax benefits provided to retirement plans are listed along with employer-provided health plan deductions and exemptions, principal residence interest deductions, and deductions for state and local taxes (other than property taxes)  as the Big Four tax expenditures.  However, unlike the other three, retirement plan deductions and exclusions are not “freebies”.  The government never recovers its “foregone” income on the other three, but the retirement plan benefit is a deferral.  Thus, the only thing that might be foregone is the time value of money, but even that depends on whether tax rates and income situations change.  In other words, the retirement plan system is potentially mistreated in the process when contributions to plans are looked upon for their tax expenditure short-term net cost to the federal government.

Reducing the tax benefits for retirement plans that result in the tax expenditure should be viewed most cautiously during the upcoming debate and revision to the Code.  Congress needs to appreciate the impact on workers for the long-term (not just five years) should it decide to reduce the tax benefits for deductions, exemptions and deferral.  Congress needs to appreciate that its budgeting system fails to account for the present value of the recovery of income from retirement plans and instead applies a short-term partial accounting.

Industry organizations like the American Society of Pension Professionals and Actuaries (ASPPA) and the American Benefits Council (ABC) have been making efforts to educate members of Congress with regard to these issues and the distinction the retirement plan contribution benefits confer when looked at as a long-term tax deferral and not a nonrecoverable spending item.  But these organizations know that they have a steep hill to climb in getting Congress to appreciate (or maybe honor) the distinction, especially since Treasury considers the exclusions and deductions without considering the full receipt of the deferred income (as required by the Congressional Budget and Impoundment Act) and then lumps them with true “spending” tax expenditures.

To assist Congress as it embarks on the onerous task of addressing tax expenditures, the GAO in the GAO Report asks and answers several questions dealing with tax expenditures.  In the next two parts of this series, we will focus on some of those questions and answers and attempt to apply them to the tax-qualified retirement plan system.