The recent tax reform bill implemented on January 1, 2018, has garnered considerable attention, leaving many individuals and businesses curious about its implications and potential impacts on their financial standing. Among those pondering its effects are plan sponsors and business proprietors. Is the tax bill detrimental to tax-qualified retirement plans? We believe not.
How the New Tax Law Impacts Businesses
To start, the new tax law maintains the current contribution limits for 401(k) plans, bringing relief as there were concerns of possible reductions to offset tax cuts. Thankfully, all 401(k) limits remain unaffected, assuring that business owners’ retirement plan contributions remain unchanged.
Additionally, certain pass-through businesses, like S-corporations, have a new 29.6% marginal tax rate, comprising a 37% tax rate with a 20% discount. However, it’s essential to note that this rate isn’t universally applicable to all pass-through entities. Specific categories of companies are ineligible for this discount, as detailed below.
C-corporations, on the other hand, face a new 21% tax rate, accompanied by additional taxes on dividends when withdrawing profits. To avoid potential double taxation, many smaller C-corporations opt to pay their owners a salary through a W-2, subjected to individual income tax rates, with the top rate now set at 37%.
Impact on Plan Sponsorship
Despite fluctuations in tax rates, qualified retirement plans continue to offer the significant benefit of tax-deferred growth. Even investing money that would have faced a 29.6% tax, with a 37% tax rate upon withdrawal, remains advantageous, as detailed below.
Admittedly, retirement plans become more appealing when pre- and post-retirement tax rates align. Hence, there is a reduced incentive for certain pass-through entities. Nevertheless, for many pass-throughs and C-corporations, the new tax law has only a minimal impact. A deeper dive into real numbers paints a clearer picture.
Illustrating the Effects
For example, let’s consider a company where owners fall within the highest tax bracket of 39.6% in 2017. They contemplate a $50,000 employer contribution to their retirement plan, allowing it to grow at 7% over 20 years. Assuming a 39.6% tax rate at retirement, would this investment prove wise? Under the old rules, sponsoring such a plan would save them $34,319.13 due to tax-deferred growth.
Now, let’s examine the same scenario under the new tax law in 2018.
- For a C-Corporation: With a small C-corporation, they’d face a 41% tax if distributing profits through dividends, resulting in total tax savings of $33,466.17 due to reduced marginal rates from 39.6% to 37%.
- Professional Pass-Through Business: For firms providing professional services, the effect remains negligible. Their total tax savings align at $33,466.17 due to the transition from a 39.6% to 37% marginal rate. A few in this category may vary slightly, as income below $315,000 falls within a 29.6% tax bracket.
- Other Pass-Through Entities: The noticeable difference arises for companies involved in manufacturing or possessing significant capital requirements (or those in engineering or architectural fields). While their incentive to sponsor a retirement plan might slightly diminish due to a 20% deduction on taxable income, their total tax savings would still reach $23,056.94. Despite the reduction in some cases, there remains a compelling tax advantage in sponsoring and contributing to a retirement plan.
Conclusion
The new tax bill maintains the advantages of retirement plans for business owners. Moreover, the tax deduction on 401(k) contributions gains enhanced significance for employees, who can benefit from it even while using the newly increased standard deduction. Sponsoring a retirement plan continues to be a strategic move under the revised tax plan. If you’re contemplating plan sponsorship for your business and wish to ascertain potential tax savings, contact our office today.
Source: The Farmer & Betts