The High-Earner Tax Break That Democrats Forgot
(Bloomberg Opinion) -- Democrats plan to increase taxes for the wealthiest Americans partly by limiting some juicy retirement tax breaks. Much of what they’ve proposed in the House of Representatives takes aim at supersized individual retirement accounts and the exotic tactics used to create them. Think of what venture capitalist Peter Thiel did to accumulate $5 billion tax-free.
But there's a separate category of retirement plans that tax-the-rich Democrats have overlooked. Known as cash balance plans, they're used by millions of high-income professionals such as doctors, lawyers and financial executives to avoid paying taxes on hundreds of thousands of dollars they earn each year.
For lawmakers who say they want to tighten the menu of tax breaks for well-off people who are already saving for retirement, these plans would seem to be low-hanging fruit.
In a cash balance plan, employers can make annual contributions of more than $300,000 for older workers. That’s almost five times higher than the $64,500 upper limit set by the Internal Revenue Service for annual employee and employer contributions to a 401(k) plan, the most common retirement-savings vehicle.
The rationale for the generous contribution limit is that cash balance plans are technically pension plans, which means employers make contributions according to calculations tied to a final payout. Pensions obligate employers to pay workers a certain amount of money when they retire. That’s different from 401(k) plans, which invest contributions from employees and sometimes employers and pay out whatever those investments eventually yield.
But unlike a traditional pension, which typically gives employees a monthly stream of income for life, a cash balance plan provides a lump sum when a worker leaves a job or retires.
Years ago, employees who contributed to a 401(k) could not take full advantage of a pension plan, but those restrictions were repealed in the late 1990s. Since then, cash balance plans have exploded in popularity, with assets now totaling more than $1 trillion. And they're often paired with 401(k)s so that account holders can expand their tax savings.
A hypothetical example provided by University of Chicago law professor Daniel Hemel and tax attorney Steve Rosenthal is helpful in showing how cash balance plans can turbocharge retirement savings. An employee who maximized contributions to a 401(k) and a cash balance plan during the course of her career, and invested those savings, would wind up with an IRA worth $13.4 million. Without the cash balance contributions, the same person’s IRA would have totaled $7.5 million.
House Democrats have introduced some restrictions on IRAs and 401(k)s, but have remained silent on cash balance plans. For example, they've said savers can't make additional IRA contributions if they earn more than $400,000 a year and have assets in IRAs and 401(k)s totaling more than $10 million. And they've called for mandatory distributions for those accountholders.
If a cash balance plan were rolled over into an IRA, it would be included in that $10 million calculation, but if it's separate, employees would be off the hook.
Democrats probably preserved cash balance plans because they're legally pension programs governed by different rules from IRAs or 401(k)s.
But Congress could require employees to choose whether to participate in a 401(k) or a cash balance plan, not both. If the Democrats' plan stays as is, it will only drive more interest in cash balance plans.
As lawmakers debate tax and spending measures, they should remember that the federal government spends more money on tax breaks for retirement savings, which disproportionately benefit the wealthiest, than for any other tax-related expense (such as the tax break for long-term capital gains or the child tax credit). Restricting the use of cash balance plans could help cut some of those costs.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Alexis Leondis is a Bloomberg Opinion columnist covering personal finance. Previously, she oversaw tax coverage for Bloomberg News.
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