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Tuesday, December 23, 2014

Tax Law Proposals Will Cut by 50% the Pre-Tax Elective Deferral Limit

Many people in Congress believe the federal government needs additional tax revenues and Congress is considering changes to accomplish this goal. This article discusses the proposed law changes for 401(k), 403(b) and governmental section 457(b) plans. An adjacent article discusses the proposed IRA changes. Except as stated otherwise, the new laws, if enacted, would be effective for the 2015 tax year. Time will tell if these or similar changes will be enacted.

Proposed change #1. Reduce the 2014 annual maximum 401(k) limit from $17,500/$23,000 to $8,750/$11,500 for Pre-Tax Elective Deferrals.

The $17,500 limit applies to those individuals younger than age 50 and the $23,000 limit applies to those individuals age 50 or older. Under existing law a participant may make both pre-tax elective deferrals and post-tax elective deferrals totaling $17,500/$23,000. Post-tax elective deferrals are called designated Roth contributions.

The right to make pre-tax deferrals would be reduced 50%. As under existing law, an employer would not be required to write its 401(k) plan to give the participants the right to make designated Roth contributions. But there would now be large tax incentive to do so. The only way for a person to make the maximum elective deferrals of $17,500 and $23,000 is for an employer to have a 401(k) plan authorizing designated Roth elective deferrals. In fact, an employer could restrict its 401(k) plan so that the only type of elective deferral which could be made by plan participants would be Designated Roth contributions.

The federal government at least on a short term basis will immediately realize more tax revenues from this change. Remember that a pre-tax elective deferral reduces a person’s income subject to federal taxation. For example, a 51 year old person earning $100,000 and deferring $23,000 would see his/her taxable income increase to $88,500 from $77,000 and thus he/she will pay income taxes on the additional $13,500. An individual would be able to make Designated Roth elective deferrals assuming the employer’s 401(k) plan authorizes such contributions.

This change would be effective for 2015 and such limits would not be changed until 2023. That is, the cost-of living adjustments would be suspended.

Proposed change #2. Under existing law the amount of compensation used to determine a person’s maximum pension contribution is $210,000 with a maximum contribution amount of $52,000. This limit is to be adjusted by a cost-of-living adjustment, but only if the adjustment is $1,000 or any multiple of $1,000. For example, the maximum contribution for 2015 will be $53,000 if this proposed change is not adopted. This annual adjustment would be suspended until 2023. Again, this change will raise revenue.

Proposed change #3. Beneficiaries of pension plans would become subject to the new RMDs rules very similar to those discussed within the IRA article. Again, this change would raise revenue.

Proposed change #4. In a limited situation there is a loophole in the RMD rules applying to a person who becomes a 5% owner after the year he or she attained age 70½, but he or she is still working. Must this person take an RMD now that he/she has become a 5% owner. The law does not clearly require such a distribution. Under existing law, a plan participant who is not a 5% may have a required beginning date of the April 1 of the year following the year he/she separates from service if such year is later than the year he/she attains age 70½. That is, he/she is not subject to the general rule that a person’s required beginning date is April 1 of the year following the year he/she attains age 70½. However, a participant who is a 5% in the year he/she attains age 70½, then such person has a required beginning date of April 1 following the year he/she attained age 70½.

Under the proposal, this person’s required beginning date is defined the April 1 of the year following the year he or she became a 5% owner regardless that the person has not yet retired.

Proposed change #5 will reduce the age for allowable in-service distributions to age 59½ for all plans – profit sharing, pension, 403(b) and governmental 457(b) plans. An employer may write its plan to provide for in-service distributions, but it is not required to do so. Under current law the earliest a pension plan may be written to allow an in-service distribution is age 62.

Proposed change #6 will repeal the requirement that a participant is prohibited from making elective deferrals for 6 months once he/she receives a hardship distribution of his/her elective deferrals. A participant receiving a hardship distribution would not be prevented from making subsequent elective deferrals for any period of time.

Proposed change #7 would revise the rollover rules applying to a distribution which has been reduced by a loan offset. It would not change existing law that a deemed distribution arising from a loan default is ineligible to be rolled over even though the participant must include such amount is his/her income and pay the 10% additional tax, if applicable. In the case of a loan offset, the participant is eligible to roll over the amount of the loan offset, but he/she must comply with the 60-day rule. For example, Jane Marple has a 401(k) account balance of $49,000 of which $8,000 is a loan made to herself. She instructs to directly rollover the non-loan amount of $41,000 to a traditional IRA. She is eligible to rollover such $8,000 but she must come up with the $8,000 and do so within the 60-day limit. If she does not do so, she will be required to include the $8,000 in her income, pay tax on it plus the 10% tax if applicable.

A new law would apply a new deadline to a participant in Jane Marple’s situation to roll over the $8,000 or some portion thereof. The new law would be very generous, she would have until her tax filing deadline (including extensions) for filing the federal income tax return for the tax year during which the plan loan offset occurs. For example, if Jane Marple directly rollover her $41,000 on January 30, 2015, she would have until April 15, 2016 to make a rollover contribution of $8,000 and such deadline could be extended to October 31, 2016 if she had a tax extension.

Proposed change #8 would revise the rules applying to contributions to 401(k), 403(b) and governmental 457(b) plans to coordinate such rules. Presently contributions to a governmental 457(b) plan are not coordinated. In addition, there would be repeal of the rules allowing special catch-up and additional contributions to 403(b) and governmental 457(b) plans at certain times. And there would be repeal of the special rules allowing employer contributions to section 403(b) plans for up to 5 years after termination of employment and the special rules for church employees and missionaries.

Proposed change #9. A distribution from a governmental section 457(b) to an individual not yet age 59½ would become subject to the 10% additional tax. Present law does not impose this tax.

The primary purpose of most of the proposed law changes is to raise additional revenue. Lowering the maximum limit of pre-tax elective deferrals will accomplish this goal as will imposing the 5-year on most inheriting beneficiaries. The 5-year rule seems very harsh when it is more likely that relatively large balances will be within 401(k), 403(b) or section 457(b) plan. Time will tell if these proposed changes will be enacted into law.

Posted by James M. Carlson at 14:30.33