Pension systems avoid financial hit initially proposed in recent national tax reform act
Although the gross income of state and local public pension plans are exempt under a part of the Internal Revenue Service code, the unrelated business income tax would have required the plans to pay taxes on direct investments, such as real estate and private equity. News of the tax provision's exclusion from the final tax reform legislation is a relief for many in the pension world who feared the tax would have made it harder for state and local plans to pay down unfunded liabilities.
By Allen Jones, TEXPERS Communications Manager
In December, Congress passed the most significant piece of tax reform legislation in more than three decades. Among tax code revisions, the Tax Cuts and Jobs Act of 2017 lowered tax rates and changed income ranges, increased minimum tax exemptions, and provided tax relief for corporations. Congress needed to identify ways to pay for it, says Gary Lawson, a pension attorney with law firm FisherBroyles. The Congressional Budget Office estimates the act will add $1.45 trillion to the national debt over 10 years.
“[Legislators] obviously were going to take away from Peter to pay Paul,” Lawson says.
He says many in the pension industry feared congressional leaders had something up their sleeves that would impact the pension tax world, but no one knew what it exactly was going to be. House Republicans initially proposed extending the unrelated business income tax, known as UBIT, to public pension plans but ended up removing the provision from a subsequent bill that eventually passed both houses.
Tax-exempt state colleges and universities are often liable for unrelated business income tax on business income from trade “that is not substantially related to the charitable, educational, or other purpose that is the basis of the organization's exemption,” according to the Internal Revenue Service. For example, a university owns a spaghetti company someone left it. Revenue from the business is unrelated taxable income.
“It puts the university on the same level as a private business that isn't tax-exempt,” Lawson says.
Public pension plan officials pushed back on the idea of extending the tax to their pension funds. According to the National Council on Teacher Retirement, the UBIT wasn't the only pension change initially included in either House or Senate versions of the tax reform act. In a newsletter distributed Jan. 2 to its members, the organization listed:
- Changes to hardship withdrawals from 401(k) plans, permitting employers to choose to allow hardship distributions that could also include account earnings and employer contributions
- Repeal of the special rules allowing additional elective deferrals and catch-up contributions under section 403(b) plans and governmental section 457(b) plans, thereby applying the same limits to elective deferrals and catch-up contributions as apply to section 401(k) plans
- A provision would have immediately taxed compensation set aside in non-qualified deferred compensation plans that could also have impacted public pension “excess benefit” arrangements under IRS code section 415(m).
According to the council's analysis of the tax reform legislation, “very few changes affecting pensions, in general, were adopted,” including:
- Conversions of a Traditional IRA contribution to a Roth contribution can no longer be characterized as a Traditional IRA contribution, as was previously permitted
- Plan participants with outstanding plan loans now have until the deadline for filing their federal income tax returns to repay the loans
- Length of service awards for public safety volunteers, which previously were not treated as deferred compensation as long as the amount was $3,000 or less, have this limited increased to $6,000 in 2018, which cost-of-living adjustments made to it after that.