- A Soft Landing from the Fiscal Cliff for Employee Benefits
- January 7, 2013 | Authors: Vicki M. Nielsen; David S. Rosner
- Law Firm: Ogletree, Deakins, Nash, Smoak & Stewart, P.C. - Washington Office
Well, Congress in the season of giving has provided plan sponsors and participants with multiple beneficial opportunities to start 2013. Congress passed the American Taxpayer Relief Act of 2012 (H.R. 8), also known as the “Fiscal Cliff” legislation, on January 1, 2013, and President Obama signed the legislation on January 2, 2013. This legislation significantly expands the ability for participants to convert non-Roth accounts within 401(k), 403(b), and 457(b) governmental plans to Roth accounts without withdrawing amounts from the plan. This provision is expected to raise 12.2 billion over 10 years to offset the loss of revenue stemming from the sequestration delay. The Fiscal Cliff legislation also addressed the tax exclusions for employer-provided educational and adoption assistance, which were both scheduled to expire at the end of 2012, re-established the parity between mass transit and parking fringe benefits that expired at the end of 2011, and addressed dependent care assistance benefits. The Fiscal Cliff legislation does not, however, avoid the expiration of the payroll tax cuts that were in effect for 2011 and 2012, or the January 1, 2013 effective date for the new Medicare taxes.
Roth Conversion Opportunity
Previously, the Small Business Job Act of 2010 (SBJA) introduced in-plan Roth rollovers effective for transfers occurring after September 27, 2010. However, under the SBJA, pre-tax elective deferrals could only be rolled over upon a distributable event such as:
- Attaining age 59½
- Termination of employment
The Fiscal Cliff legislation permits participants to utilize in-plan conversions (for both pre-tax elective deferrals and employer contributions) to a Roth account at any time without having to incur one of the above listed distributable events provided the plan specifically permits this in-plan conversion feature.
The in-plan conversion is taxable in the year of conversion. However, any subsequent earnings and qualified distributions from Roth accounts will not be taxable. This conversion is quite popular because it serves as a flexible retirement planning tool for participants, especially if they expect their tax rates to increase at or during retirement.
This provision is effective for transfers occurring after December 31, 2012. And so plan sponsors may immediately add this to their plans. Plan sponsors should evaluate their 401(k) plans to determine whether this feature is desirable. A plan sponsor must permit Roth accounts within the plan to take advantage of this expansion of this in-plan conversion feature. Since this relates to a discretionary change, employers must adopt the amendment by the end of the plan year in which the change is effective. For example, employers that wish to utilize this in-plan conversion feature during 2013 must amend their plans by December 31, 2013 (assuming a calendar year) unless the IRS provides an extended deadline.
Plan sponsors will also need to revise their Summary Plan Description to properly communicate this change to their employees and include a description of the expanded in-plan Roth conversion in the distribution package provided to participants in connection with a distribution request.
2013 Tax Increases
As widely reported, the Fiscal Cliff legislation permanently extends the Bush era tax cuts for many taxpayers while increasing tax rates for individuals with taxable income above statutory thresholds.
The Fiscal Cliff legislation does not, however, affect payroll tax increases scheduled for 2013. As a result, the temporary payroll tax holiday for employees expired on December 31, 2012 causing the employee portion of the Social Security (FICA) payroll tax to increase on all employees from 4.2% to 6.2% effective January 1, 2013. For example, if an employee makes $50,000 in 2013, the employer must withhold an additional $1,000 in taxes from the employee’s wages in 2013. The IRS has released Notice 1036, which provides the 2013 tax withholding tables for employers. Notice 1036 provides that employers have until February 15, 2013 to implement the increased 6.2% employee FICA tax rate, and until March 31, 2013 to correct any underwithholding of FICA tax.
The new year brings two additional payroll tax increases, unrelated to the Fiscal Cliff legislation. First, the wage base to which the FICA tax applies is increased from $110,100 to $113,700 for 2013. Second, the new additional Medicare tax requires taxpayers to pay an additional 0.9% tax (in addition to the 1.45% tax that applies to all wages) on wages in excess of $200,000 ($250,000 for married individuals filing jointly; $125,000 for married individuals filing separately). Although the 0.9% additional Medicare tax is only imposed on the employee, employers are required to withhold the 0.9% additional Medicare tax (in addition to the 1.45% tax) from wages paid to an employee in excess of $200,000 in a calendar year.
Also effective January 1, 2013, an additional 3.8% Medicare tax will be applied to net investment income for taxpayers with an annual income of more than $200,000 or $250,000 for joint filers. This additional tax will apply to the sale of company stock received by employees and directors under equity incentive plans and dividends payable on such stock. Equity-based compensation taxed as wages (e.g., stock options and stock appreciation rights at exercise, restricted stock at vesting, restricted stock units or performance shares at payment, and dividends or dividend equivalent rights earned on restricted stock or restricted stock units) is not subject to this additional 3.8% Medicare tax because wages are not treated as net investment income.
Educational Assistance and Adoption Assistance
The Fiscal Cliff legislation extends indefinitely the exclusion from wages for reimbursements of employer-provided educational assistance and amounts paid by an employer under a qualified adoption assistance program. Under Internal Revenue Code Section 127, employers may reimburse an employee on a tax-free basis up to $5,250 for qualified tuition assistance for undergraduate and graduate education, even if the courses are not job-related. Under Code Section 137, employers may reimburse an employee on a tax-free basis up to $12,650 (for 2012) for expenses related to the adoption or attempted adoption of a child, including reasonable and necessary adoption fees, court costs, attorneys’ fees, traveling costs, and other expenses. The amount that may be excluded from wages as employer-provided adoption assistance is indexed for inflation. The IRS has not yet released the 2013 inflation adjustments for adoption assistance.
Qualified Transportation Benefits
The Fiscal Cliff legislation re-established, for 2012 and 2013 only, the parity that existed in prior years between mass transit and work-related parking benefits. In 2010 and 2011, employers were allowed to withhold up to $230 a month in pretax funds from employee pay (or provide up to the same amount in a tax-free subsidy to the employee) for mass transit commuting expenses or work-related parking expenses. In 2012, the transit benefit subsidy dropped to $125 (and the parking subsidy increased to $240) after Congress failed to extend a number of temporary tax provisions at the end of 2011. The Fiscal Cliff legislation retroactively increases the monthly limit for mass transit commuting expenses for 2012 (up to $240) and extends parity through December 31, 2013. The IRS has not released the 2013 inflation adjustments for the monthly limit applicable to qualified transportation benefits. When the 2013 monthly limits are released, the limit for mass transit and work-related parking will be equal.
Dependent Care Assistance Benefits
Under Internal Revenue Code Section 129, employers may exclude on a tax-free basis up to $5,000 in employer-provided dependent care assistance from an employee’s wages, but the exclusion may not exceed the lesser of the employee's earned income or that of the spouse. The Fiscal Cliff legislation extends indefinitely prior legislation that increased the amount of deemed earned income for spouses who are full-time students or unable to care for themselves.
The popping of champagne corks due to averting the fiscal cliff may be premature because the legislation did not address any long-term fiscal issues—namely reducing the budget deficit and reforming the Internal Revenue Code. Deadlines for addressing “mini-cliffs” such as the debt ceiling, budget sequestration, and fiscal 2013 appropriations are imminent, so budget issues will be on the legislative agenda in 2013. This also raises the possibility that lawmakers could seek changes to the tax treatment of various employee benefit and compensation programs in order to raise revenue needed to offset the costs of addressing those issues.