The Fiscal Cliff Act: A Thirteenth Hour Compromise¹
Just before 2 a.m. on January 1, 2013, the Senate passed the American Taxpayer Relief Act of 2012 (ATRA) to avoid the much maligned fiscal cliff. America breathed a sigh of relief when the House of Representatives made it official several hours later. This thirteenth hour compromise, also known as the Fiscal Cliff Act, preserved most of the George W. Bush-era tax cuts and extended other tax provisions as well. While ATRA is not fundamentally retirement plan focused, its provisions impact plan participants from a tax perspective and may influence decisions about how to participate in their retirement plans.
The Fiscal Cliff
The now short-timer chairman of the Federal Reserve, Ben Bernanke, coined the term "fiscal cliff" in February, 2012. In coining this term, Mr. Bernanke was referring to the dramatic decline in the nation’s budget deficit that was expected as a result of the increased taxes and reduced spending required under previously enacted laws, including the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003.
The potentially stifling effect of the fiscal cliff was perhaps best summed by recent statements from the Congressional Budget Office (CBO). In a December, 2012 update on the budget and economic outlook for the period 2012 to 2022, the CBO estimated that the massive decline in the deficit would probably lead to another American recession, with a 9% unemployment rate in the back half of 2013. The collective US government drove hard to avoid this dark conclusion during colorfully embattled late-December political negotiations.
Summary of ATRA
ATRA represents the much anticipated bipartisan agreement necessary to avoid the dangers of the fiscal cliff—for now at least. Saving the provisions most relevant to retirement plans for the next section, what follows below is a brief summary of ATRA’s most meaningful provisions.
- ATRA reinstated the marginal ordinary individual income tax rates mandated under prior law. They are: 10%, 15%, 25%, 28%, 33% and 35%. A new rate, however, was added to tax individuals earning more than $400,000 (single), $450,000 (head of household), or $475,000 (married filing jointly) to pay 39.6% on those dollars above the bracket threshold.
- The ability to take a personal exemption or itemize deductions was extended to income earners of less than $250,000 (single), $275,000 (head of household), or $300,000 (married filing jointly).
- Capital gains tax rates were set as follows: 20% for individuals in the top income tax rate bracket, 15% for individuals in the middle brackets, and 0% for earners paying the 10% or 15% marginal income tax rate.
- ATRA does not provide relief from a 2% payroll tax increase from 4.2% to 6.2%. The US labor force will see a smaller paycheck as a result, which is likely to most rudely affect employees in the lower income brackets.
- The Alternative Minimum Tax was permanently indexed for inflation, saving millions of Americans from potentially being subject to it.
- The estate and gift tax exclusion was retained at $5M, to be indexed for inflation annually. Unused exclusion amounts by a decedent spouse may be added to the surviving spouse’s exclusion amount. The top estate and gift tax rate was increased from 35% to 40%.
- Miscellaneous credits, exclusions and deductions provided for under the Economic Growth and Tax Relief Reconciliation Act of 2001 that expired on December 31, 2012 were permanently reinstated. A few temporary provisions that expired on December 31, 2011 were also permanently reinstated under ATRA. Certain tax liability credits carved out from the American Recovery and Reinvestment Act of 2009 were extended through 2018. ATRA also included a flurry of business tax provisions and energy credit extenders.
In-plan Roth Conversions
Several types of retirement plans may allow participants to make after-tax deferrals to the plan without future tax liability on investment earnings. These contributions are known as Roth contributions, and 401(k), 403(b) and governmental 457(b) plans have the option to allow them. The provisions of ATRA that perhaps most directly impact retirement plans relate to in-plan Roth conversions.
In-plan Roth conversions essentially allow participants to convert any amounts accumulated in their retirement plan accounts to Roth status. The amount converted is subject to ordinary income tax in the year of conversion, but is not subject to the 10% premature withdrawal penalty if converted prior to age 59½. The primary benefit of new found Roth status is that earnings on Roth accumulations are not subject to tax upon the participant’s eventual withdrawal of them.
Under prior law, a plan sponsor could allow participants to convert accumulations inside the plan to Roth status only if the participant was eligible to receive a distribution of the converted assets. ATRA, which replaces any prior law, provided relief from the distribution eligibility requirement. So long as the plan allows for Roth contributions, adopting plan participants are now able to conduct an in-plan Roth conversion without the need for distribution eligibility.
Adopting the in-plan Roth conversion provision of ATRA may not be as easy as for a plan sponsor as it seems. Substantial due diligence is required before moving forward. Not all retirement plan recordkeeping vendors have the administrative capabilities required to support an in-plan Roth conversion in an automated way. Appropriate internal procedures and controls must be set to administer the in-Plan Roth conversion provision at the employer level. Adopting employers must also appropriately amend their plan documents to allow these conversions. Communications to employees educating them about the changes and how they can request conversions will be required of adopting employers as well.
Despite the passage of ATRA and associated short-term celebration, Congress remains challenged by several other substantial economic hurdles. The debt ceiling is now in sharp focus as US lawmakers begin to tackle the question of whether to raise the limit on national debt. The US sovereign credit rating almost certainly hangs in the balance of these historical decisions. Our legislative assembly must also determine how to address the spending cuts merely sequestered for two months under ATRA. Then, a new budget must be scratched out by March 31, 2013 to replace the temporary budget in place today. These monumental decisions will almost certainly have broad economic impact. They will also determine how Americans are taxed to generate the revenue required to support the overall plan. How these issues are resolved may play a role in how employees participate in employer sponsored retirement plans in the months and years to come.
¹Information contained herein is provided "as is" for general informational purposes only and is not intended to be completely comprehensive regarding the particular subject matter. While Multnomah Group takes pride in providing accurate and up to date information, we do not represent, guarantee, or provide any warranties (express or implied) regarding the completeness, accuracy, or currency of information or its suitability for any particular purpose. Receipt of information herein does not create an adviser-client relationship between Multnomah Group and you. Neither Multnomah Group nor any of our advisory affiliates provide tax or legal advice or opinions. You should consult with your own tax or legal adviser for advice about your specific situation.
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