The Tax Reform Act of 2014 proposed by Ways and Means Committee Chair Dave Camp (R-Mich.) would overhaul the tax code and change retirement, compensation, health and other employer-provided benefits, as well as individual and corporate tax rates, deductions, tax exclusions and credits.
Early in 2013, Representative Camp and ranking member Sandy Levin (D-Mich.) established 11 working groups to recommend reforms to the tax code. The Ways and Means Committee also sought comments and recommendations from the public. On May 6, 2013, the Joint Committee on Taxation released a report outlining existing tax reform proposals, discussions within working groups and suggestions from the public. On February 26, 2014, Representative Camp released a discussion draft of the Tax Reform Act of 2014. This article describes some of the key proposals from the discussion draft to amend the tax preferences for benefit programs.
Retirement plan proposals
The proposed reforms would significantly change the tax treatment of qualified retirement plans and individual retirement accounts (IRAs), thus affecting employee savings and employer plan administration. The reforms would align the rules for 401(k), 403(b) and 457 plans and streamline the types of available retirement savings plans.
Focus on Roth model
Representative Camp’s tax reforms would promote Roth accounts — both Roth IRAs and Roth accounts within employer-sponsored defined contribution (DC) plans. Representative Camp’s summary notes that Roth approaches “… would help Americans achieve greater retirement security by effectively increasing the amounts they have available at retirement. Many people saving in traditional 401(k) plans do not consider the taxes that will be due upon distribution, and assume that their entire account balance will be available to them upon retirement.”
In employer-sponsored plans, the proposed reforms would limit employee contributions to traditional DC plans to one-half the maximum annual elective deferral amount and require that any additional amounts be contributed to a Roth arrangement. Under the current $17,500 limit, for example, a participant could contribute $8,750 to a traditional account and additional amounts would have to go into a Roth account. Employer plans generally would have to include a Roth account. Employers would continue contributing to traditional DC plans.
For IRAs, the proposed tax reforms would shift toward the Roth model by:
- Eliminating income limits for contributions to Roth IRAs
- Prohibiting new contributions to traditional and nondeductible IRAs
- Repealing the rule allowing Roth IRA contributions to be re-characterized as traditional IRA contributions
Suspension of limit indexing
The proposal would suspend the inflation adjustment for Internal Revenue Code (IRC) Section 415 benefit and contribution limits, maximum elective deferral limits, catch-up contributions and Roth IRAs until 2024. After the freeze ends, the Roth IRA limit would increase based on the chained consumer price index — a metric expected to result in smaller annual increases. It appears the limits for employer-sponsored plans would be indexed based on the traditional consumer price index for urban consumers (CPI-U).
Other retirement proposals
Representative Camp’s tax reforms would also change many other rules for employer plans:
- Repeal the exception from the early withdrawal penalty for distributions taken for first home purchases and educational expenses and apply the early distribution penalty to governmental 457 plans
- Require the Internal Revenue Service to allow employees to continue contributing to a plan after taking a hardship distribution
- Extend the period allowed for employees to pay back outstanding loans upon plan termination or separation of employment to the filing due date for the individual’s tax return
- Allow all plans, including defined benefit plans and state and local government DC plans, to provide in-service distributions beginning at age 59-1/2
- Repeal the exclusion for net unrealized appreciation from income for distributions of employer securities from tax-deferred retirement plans
- Align limits under 403(b) and 457 plans with 401(k) plan limits, with no additional limits for different classes of employees
- Disallow new Simplified Employee Pensions (SEPs) and Savings Incentive Match Plan for Employees (SIMPLE) 401(k) plans. Workers could continue contributing to existing plans, and SIMPLE IRAs would remain available. The start-up credit for plans sponsored by small employers would be repealed.
- Provide that if an employee becomes a 5% owner of the company after age 70-1/2 but before retirement, required minimum distributions would have to begin on April 1 of the next year
- Eliminate “stretch IRAs” (non-spouse beneficiaries would have to take distributions from inherited IRAs, DC plans and defined benefit plans within five years, unless they are disabled, chronically ill or less than 10 years younger than the deceased; minor children would have to take distributions by age 26)
Health care proposals
There is less focus on health care than on retirement and compensation. While the proposed reforms generally leave the Patient Protection and Affordable Care Act (PPACA) in place, some provisions would affect health care reforms, health care benefits and medical expenses.
The proposal would make the following changes to the PPACA:
- Repeal the excise tax on medical device manufacturers
- Repeal the prohibition on tax-free payments or reimbursements from health flexible spending accounts (FSAs), health reimbursement arrangements and health savings accounts (HSAs) to pay for over-the-counter medications without a prescription
- Repeal the nonprofit Consumer Operated and Oriented Plans (CO-OPs) that are being offered in some public health insurance exchanges
- Repeal the tax credit for health coverage offered by small employers
Other health-related changes would:
- Repeal the health coverage tax credit, which was generally available to trade-displaced workers and Pension Benefit Guaranty Corporation (PBGC) recipients over age 55 until it expired on December 31, 2013
- Repeal the itemized deduction for out-of-pocket medical expenses
- Repeal the above-the-line deduction for contributions to Archer medical savings accounts (MSAs) (existing Archer MSA balances could be rolled over to an HSA)
The employee tax exclusion for some employer-provided health benefits (amounts reported on W-2s, contributions to HSAs and salary reduction contributions to health FSAs) would be capped at the 25% tax bracket.
Under the reforms, carried interest would be treated as ordinary income, and all severance payments would be subject to income and employment taxes. Most of IRC Section 409A would be repealed and a new Section 409B would include nonqualified deferred compensation (and related earnings) in gross income as soon as there was no substantial risk of forfeiture of the right to the compensation. Previously earned amounts would be temporarily grandfathered — delaying their inclusion in income. Regulations would allow for acceleration of payments. Section 409B would also extend the short-term deferrals exemption to six months after the end of the taxable year.
The $1 million deduction limit under IRC Section 162(m) would be expanded to:
- Repeal the exception for performance-based compensation and commissions
- Change the definition of covered employee under Section 162(m)(3) to include the chief executive officer, chief financial officer and three next-highest compensated officers (and once someone was designated as a covered employee, he or she would remain a covered employee)
- Apply the limit to beneficiaries of covered employees
- Apply the $1 million compensation limit to tax-exempt organizations by imposing a 25% excise tax on excess compensation (including severance or parachute payments paid to the five highest-paid employees)
Corporate-owned life insurance (COLI) would no longer be exempt from the pro rata interest expense disallowance rule for contracts covering employees, officers or directors, other than 20% owners of a business that is the owner or beneficiary of the contracts.
Proposed tax brackets
The act would establish three tax brackets: 10%, 25% and 35%. The 35% bracket would apply to taxpayers with modified adjusted gross income (MAGI) of $400,000 (individuals) and $450,000 (married couples). Certain tax preferences, including those for pretax contributions to DC plans, would be capped at the 25% bracket. In general, MAGI would equal the AGI plus the following:
- Standard deduction
- Itemized deductions (except charitable contributions)
- Excluded foreign earned income (including income from Puerto Rico and other U.S. possessions)
- Tax-exempt interest
- Employer contributions to health, accident and DC plans (to the extent excludable)
- Amounts deducted for health insurance premiums for the self-employed
- Amounts deducted for contributions to HSAs and excluded Social Security income
Other proposed tax reforms
- The act addresses worker classification and establishes a safe harbor for services performed and payments made after 2014.
- The $5,250 exclusion for undergraduate and graduate education under IRC Section 127 would be repealed.
- Qualified parking benefits and qualified transportation benefits would be frozen at their current limits of $250 per month and $130 per month, respectively. The limits would not be indexed for inflation. The act would repeal reimbursement of qualified bicycle commuting expenses and the employer deduction for transportation fringe benefits.
- Tax credits for dependent care, adoption and employer-provided child care would be repealed. The income exclusions for employer-provided dependent care and adoption assistance programs appear to continue.
Little chance for near-term action
The full reform proposal is not expected to advance, but some elements could gain traction, especially those that raise revenue. Proposals to freeze the indexing of retirement plan and IRA limits, shift contributions from traditional to Roth retirement programs, eliminate stretch IRAs, and limit the value of retirement and health care tax benefits for higher-income taxpayers are revenue raisers that have received recent legislative attention. The focus on these provisions is likely to continue, and other provisions may attract new attention as a result of the discussion draft.