Last fall, tax reform seemed to be an all-consuming obsession in Washington. By December, both houses of Congress had worked out their differences and sent a bill to the president’s desk to sign. That tax bill became effective on New Year’s Day, January 1, 2018.
Now, everyone is wondering what it actually means. Will my taxes go up or down? Have I lost all of my deductions? How will it affect my business and the retirement plan we sponsor? We dug into the new tax plan to get you some answers.
Changes To Retirement Plans
There was a lot of fear in October and November that contribution limits would be reduced for retirement plans like 401(k)s and 403(b)s. Luckily, that didn’t happen and all current contribution limits were preserved.
The only direct change to these defined contribution plans has to do with loans. Loans are often allowed on 401(k) or 403(b) accounts of the lesser of $50,000 or half of the account balance. The account owner then gradually pays back the loan with interest. Previously, if the account owner left their job, they only had 60 days to repay the loan before it would be counted as an early withdrawal and be subject to regular income taxes and a 10% penalty.
That was under the old law. Under the new law, which applies to loans taken out after January 1, 2018, workers have a lot more time to pay back their loans when they leave a job. They now have until October of the following year (the due date for that year’s tax return with an extension) to repay the loan. The repayment can go back into the same 401(k), into an IRA, or into a new employer’s 401(k).
Changes For Businesses
Though the direct changes to retirement plans were limited, there were significant changes for businesses that can affect retirement plans indirectly. The biggest changes come in the form of lowered tax rates.
For C corporations, the tax rate was dropped down to 21%. Pass-through businesses, like S corporations, are subject to the new, lower individual tax brackets that range from 10% to 37%. However, some pass-through entities are now eligible for a 20% deduction, which brings their top marginal rate down to 29.6%. Businesses that offer professional services, not including engineering and architecture firms, are not eligible for the 20% deduction.
Is Sponsoring a Retirement Plan Still A Good Idea?
Though the tax rate for C corporations was drastically cut, it doesn’t greatly diminish the tax savings an owner gets for contributing to a retirement plan. The 21% tax rate must be added to the 20% tax on dividends for an overall 41% tax. Owners who take their profits through a W-2 are still subject to the higher individual tax rates, just like owners of professional pass-through businesses.
The biggest difference is for those eligible for the 20% deduction for pass-through companies. Some might think that they no longer have reason to sponsor a retirement plan under the lower tax rates. However, they can still save a lot on taxes with a retirement plan, just not quite as much as before.
While current tax rates may be lower, tax-deferred employer-sponsored retirement accounts are still the best way to save for retirement. They haven’t gotten better because of the new tax plan, but they aren’t really hurt by it either.
Sponsoring a retirement plan for your business is still a smart move, even under the new law. If you are thinking of sponsoring one or have other questions about how the new tax plan might affect your current retirement plan, email me today at firstname.lastname@example.org.
About Kenny Phan
Kenny Phan is a Managing Partner at FinancialFocus Retirement Plan Services, a 3(16) fiduciary. He works as a pension specialist who partners with financial professionals to design and implement pension plans. His area of expertise is customized defined benefit, defined contribution, and 401(k) plans. Serving financial advisors and businesses in the greater Phoenix area, he is supported by FinancialFocus Retirement Plan Services. Together, they provide comprehensive plan design consultation, administration, document installation, compliance testing, as well as IRS and DOL reporting for qualified retirement plans.