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Guest Article

Deloitte

(From the November 7, 2005 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Tax Reform Advisory Panel Issues Final Report


The President's Advisory Panel on Federal Tax Reform on November 1, 2005 submitted its recommendations to Treasury Secretary John Snow. The final report recommends imposing a cap on the tax exemption for employer-provided health benefits and overhauling defined contribution plans and other tax-favored savings vehicles as part of a broader re-working of the federal tax code. Whether the Advisory Panel's recommendations will ever receive serious legislative attention remains an open question.

Overview

The Advisory Panel's report outlines two comprehensive tax reform plan alternatives, designated as the Simplified Income Tax Plan (SITP) and the Growth and Investment Tax Plan (GITP). Both plans are designed to simplify the current tax code, and share many common proposals. The main differences relate to taxing businesses and capital income.

The following summary focuses on the Advisory Panel's recommendations relating to employee benefits. Additional information about the Advisory Panel's report and recommendations is available on the Advisory Panel's Web site, at www.taxreformpanel.gov.

Health Benefits

Both the SITP and the GITP would cap the tax exemption for employer-provided health coverage at $5,000 for singles and $11,500 for families. The Advisory Panel chose these limits because they represent the projected national average annual amount of health insurance premiums for 2006. (The average premium for 2005 is $4,024 for singles and $10,880 for families, according to the Kaiser Family Foundation's Employer Health Benefits 2005 Annual Survey.) If recent inflation trends hold, then average premiums soon would exceed the cap because the cap would be indexed to overall inflation instead of health insurance inflation. The cap would not apply to the employer deduction for health insurance premiums paid on employees' behalf.

The Advisory Panel Report uses several arguments to justify the proposed cap. First is the fact that the employer-provided health insurance exemption will cost the government an estimated $126 billion in lost tax revenue in 2006, representing almost 90 percent of all tax expenditures associated with health care-related tax preferences. And these tax preferences tend to benefit higher-income households more than lower-income households, both because the exemption is more valuable to taxpayers in higher marginal tax brackets and because higher-income people are more likely to have employer-provided health insurance.

Also, the Advisory Panel Report asserts the exemption might cause inefficiencies in the market for health care. The tax-preferred treatment encourages individuals to buy more health insurance than they otherwise might. This, in turn, creates an incentive to consume more health services, which increases overall health spending. According to the Advisory Panel Report, eliminating the employer-provided health insurance exemption could lower private spending on health care by 5 to 20 percent.

Finally, the Advisory Panel Report suggests the exemption creates additional demand for health insurance. This has the effect of raising premiums, thus pricing some lower-income people out of the health insurance market.

Of course, these same arguments could be used to justify eliminating any tax preference for employer-provided health insurance. But the Advisory Panel Report does not go that far. According to the Report, the Panel "... recognizes that a strong system of employer-provided health insurance provides many benefits and may lead to a greater percentage of the population with health insurance. In addition, employer-sponsored group coverage reduces transaction costs and may lower premiums for some by pooling the risks of large numbers of individuals."

Other Fringe Benefits

The SITP and GITP also would eliminate most current tax preferences for other fringe benefits,including childcare benefits, group term life insurance, and educational assistance. Companies could continue offering certain in-kind benefits to all employees, such as meals at a company cafeteria, on a tax-free basis.

Retirement Benefits

Perhaps the most dramatic benefits-related proposals included in the SITP and GITP relate to employer-sponsored retirement benefits. Although the terminology is different, the Advisory Panel's proposals appear to closely track the Bush Administration's proposals to replace current tax-favored retirement plans with Employee Retirement Savings Accounts (ERSA), Retirement Savings Accounts (RSA), and Lifetime Savings Accounts (LSA). The Advisory Panel's proposals would not make any changes to the rules relating to defined benefit plans.

Both proposals would consolidate all defined contribution plans (i.e., 401(k), SIMPLE 401(k), Thrift, 403(b), governmental 457(b), SARSEP, and SIMPLE IRA plans) into a single Save at Work plan. The rules for Save at Work plans generally would follow the current rules for 401(k) plans (including the contribution limits), but with simplified qualification rules. For example, the proposals would replace current nondiscrimination rules with a single test to ensure employee contributions are not skewed in favor of highly compensated employees. However, the GITP would subject Save at Work accounts to the same tax treatment as Roth IRAs (i.e., after-tax contributions, but no tax on the earnings build-up and distributions).

Optional AutoSave features would be available for Save at Work plans. These features would include automatic enrollment, automatic increases in the employee contribution percentage, and automatic investment in "balanced, diversified alternatives with low fees, such as broad index or life-cycle funds ...." Some employers already incorporate these features in their 401(k) plans.

Additionally, both proposals would replace Individual Retirement Accounts (IRAs), Roth IRAs, deferred executive compensation plans, and tax-free inside buildup of the cash value of life insurance and annuities with Save for Retirement accounts. These accounts would operate like Roth IRAs, and be subject to a $10,000 annual contribution limit (indexed). Anyone with earned income would be permitted to contribute to Save for Retirement accounts, including those who contribute to Save at Work accounts. Also, Save for Retirement accounts could accept rollovers from Save at Work accounts.

Finally, the proposals would replace Health Savings Accounts, Archer Medical Savings Accounts, Flexible Spending Accounts, Coverdell Education Savings Accounts, and Section 529 Qualified Tuition Plans with Save for Family accounts. These accounts also would operate like Roth IRAs and be subject to a $10,000 annual contribution limit (indexed). However, anyone could contribute to Save for Family accounts. Tax free distributions could be taken at any time to pay for health or medical costs, education or training expenses, and purchases of a primary residence. Beginning at age 58 all distributions would be tax free, regardless of how they are used.

Outlook

With time running out this year, comprehensive tax reform is not at the forefront of the congressional agenda. And it may be impossible to get enough bipartisan support to enact such sweeping reform in 2006, a mid-term election year. However, it is worth noting that 2006 is the twentieth anniversary of the last time Congress enacted comprehensive tax reform, and the President at that time (Ronald Reagan) did not have the advantage of a working majority in the House. President Bush has a majority in both the House and in the Senate. So anything is still possible.


DeloitteThe information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.

If you have questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Bart Massey 202.220.2104, Diane McGowan 202.220.2077, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Carlisle Toppin 202.220.2067, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

Copyright 2005, Deloitte.


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