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aspa.org

Proposal to Exclude Nonqualified Annuity Distributions from Taxable Income Should Apply to Qualified Plan Distributions

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ASPPA opposes H.R. 4849, which will negatively affect small business retirement plan coverage, unless it is expanded to cover annuity distributions from qualified plans.

The Issue: Congress may consider whether to allow a taxpayer to exclude annually from taxable income up to 50% of the taxable portion of a lifetime payment from a nonqualified deferred annuity (up to a maximum of $20,000 in tax-free income per year). The issue is whether this exclusion, as currently drafted to apply only to nonqualified deferred annuities represents sound tax, fiscal and retirement policy.

Background: Under current law, that portion of a nonqualified annuity payment that represents the as-yet untaxed gain from investment in the annuity is taxed as ordinary income (the “exclusionary rule” under IRC Section 72).

Purchasers of nonqualified annuities may invest an unlimited amount in their annuities. Further, variable annuity holders may exchange investments without tax consequence. Annuities are also not subject to any nondiscrimination rules.

Retirement payments from qualified plans (including qualified annuities), on the other hand, derive from contributions to a retirement plan that is generally governed by a set of complex laws that significantly restrict the amount of contributions that can be made by both employer and employee. Investment in qualified plans generally is also limited by application of nondiscrimination rules, compensation limits and other plan qualification requirements.

Small Employers Will Abandon Their Retirement Plans Unless Lifetime Payouts From Retirement Plans Are Given Equal Treatment: Nonqualified annuities will have a significant economic advantage over retirement plans if only nonqualified annuities qualify for the proposed exclusion from taxable income. This would adversely affect rank-and-file workers, especially those employed by America’s small businesses, the fastest-growing segment of the US economy.

Small business owners would naturally view the back-loaded tax advantages of annuities (the exclusion from taxable income of up to 50% of the annual lifetime payment, after a tax-deferred accumulation period) as very attractive when compared to fully taxable payments from qualified plans which are also subject to costs deriving from nondiscrimination rules and administrative requirements. Thus, nonqualified annuities would become so much more attractive that many small business owners would forego establishment of employer-sponsored retirement plans. Instead, they would invest their retirement money in the now extra-tax advantaged nonqualified annuity, where they would not confront administrative rules and nondiscrimination requirements to contribute on behalf of employees in order to get the benefit for themselves.

A real-life rather typical example clearly demonstrates how this would occur. Assume a small business with two owners and 13 employees. In order for both of the owners to save the maximum annual amount allowed in their retirement plan, each owner contributes $41,000 on his own behalf. They contribute another $34,751 on behalf of their employees in order to satisfy the nondiscrimination rules. Annual plan administration costs total $2,000 for a total retirement plan cost of $118,751.

Now, compare the yields available to these owners if they use that amount to each purchase an individual nonqualified deferred annuity rather than establishing and contributing to a retirement plan. Assuming annual interest at 8%, 40% in tax liability and a normal retirement age of 65, the owners will earn an after tax lifetime annuity monthly payment of $7,834 if the contribution is invested in a nonqualified annuity. The after-tax monthly yield for a lifetime payment from contributions to a qualified plan totals only $6,296. Multiply the $1,538 differential by 12 months per year and 15 years until normal retirement, and you see that choosing a retirement plan will cost each owner $18,456 per year, or $276,840 over 15 years, assuming the owner is receiving a life annuity and lives till age 80.

In many cases, small business owners would not be able to pass up the clear economic advantage inherent in an individual annuity that qualifies for the proposed exclusion from taxable income. Consequently, fewer workers in America’s small businesses would benefit from employer-sponsored pension plans. These workers are most often middle class, lower-paid employees whose opportunities for significant savings for retirement are limited. Diminution of the employer-based system, especially among small businesses, can have no effect but to substantially lower the overall retirement savings rate among small business’ rank-and-file workers.

Data showing where America’s retirement savings come from bear this out. According to EBRI’s most recent data, only 7.1% of America’s eligible workers earning between $30,000 and $50,000 annually contribute to a traditional IRA. By contrast, 77.9% of that same class of workers participate in their employers’ 401(k) plans. Clearly employer-sponsored retirement plans – due to the power of the employer match and the convenience of payroll deductions – makes a profound difference to the retirement security of our nation’s workers.

ASPPA Position: It is essential that, if Congress grants an exclusion form taxable income for up to 50% of the taxable portion lifetime payments from a nonqualified annuity, an exclusion must be equally available to lifetime payments from qualified annuities and from lifetime annuity payments from a qualified plan. Making all forms of lifetime payout options from retirement savings vehicles equally qualified for an exclusion would avoid tilting the competitive balance away from employer-sponsored plans, especially in the case of small business. It is crucial to avoid such a tilt in order to avoid hurting rank-and-file workers whose principal source of retirement income derives from a combination of Social Security and employer-provided retirement benefits.

For more information, contact:

Brian H. Graff, Esq., 703.516.9300; bgraff@aspa.org
Dani Kehoe, Esq., (202) 547-7566; danikehoe@aol.com