By: Tim Hayes Financial Advisor - posted in: In the News - Last updated Nov 29, 2018

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How the Federal Tax Cuts and Jobs Act Can Help Solve the Public Pension Problem

Some politicians want public employees to change their traditional pensions to 401(k)-type plans,[1] pointing out that private-sector workers have already done so.

This change of retirement contribution plans has had a mixed record. It benefits those workers who often change employers because they receive employer contributions while they are working. However, it hurts workers who stay with the same employers, as those workers miss out on the employer contributions during retirement.

Also, many private-sector workers struggle with saving and investing their 401(k) retirement money. According to a 2015 Wells Fargo study, the median savings of working Americans aged 60 or older is $50,000 against a retirement savings goal of $300,000.[2]

Ted Benna, credited with inventing the 401(k) retirement plan in the late 1970s, says he never fathomed that the plan would be a substitute for traditional pensions. In light of that, he said he would conceive the 401(k) plan differently were he doing so for the first time today.[3]

Financial Planning Process

How Are Public Employee Pensions Doing?

Some states have severely underfunded their public employee pensions. This puts pressure on the politicians, as they need to either (1) go to the taxpayers to increase their taxes to make right on the pension promises, or (2) ask the public employees to give up an accrued pension benefit.

The Public Employee Pension Puzzle

 

On October 23, 2018, the PBS documentary series Frontline devoted an entire episode to the multi-trillion-dollar public pension hole, focusing on the Commonwealth of Kentucky,[4] which has systemically underfunded its pension plans by $37 billion and has tried to make up for that with aggressive investing strategies. Some of its pension systems went from fully funded in 2000 to possibly running out of money in the next three years.

The 2017 Federal Tax Act

In 2017 the US Congress passed the Tax Cuts and Jobs Act, the most significant change to the federal tax code since the 1986 tax overhaul. The Act reduces or eliminates many deductions, such as putting a $10,000 cap on state and local income and property taxes, no longer allowing for a deduction for home equity or moving expenses. It also eliminated the $4,050 per-person personal exemption.

To offset those losses, the Act increases the standard deduction from $6,500 to $12,000 per single filer (double for joint filers) and lowers overall tax rates. Thus more people will use the new larger standard deduction and pay less in federal income taxes. However, some wealthy and upper-middle-class people will end up paying more in federal taxes, because of the decrease in deductions and exemptions.

What Does All That Have to Do with Public Pensions?

Most of the 41 states with state income taxes conform in some way to the Federal Tax Code. For example, Colorado uses the federal definition of taxable income to figure state taxes owed, and taxable income is one’s income after all deductions.[5] This means any Colorado taxpayer who loses deductions and exemptions at the Federal level also loses them at the state level. And, unlike the feds, neither Colorado nor any other state has reduced its tax rates to reflect the broader tax base.

Kentucky also has a state income tax, so it, too, could see an increase in tax revenue as taxpayers there lose mortgage-interest and property-tax deductions, as well as personal exemptions, leaving some taxpayers with a much higher state income to be taxed.

Almost all income-taxed states could see more revenue as a result of the 2017 Federal Tax Cuts and Jobs Act. This gives the politicians once-in-a-lifetime opportunities to shore up their public pensions with tax revenues from higher taxes they didn’t impose.

Why Public Employee Pensions Are Worth Saving

Interestingly, public employees’ pensions are precisely what Ted Benna envisioned when he created the 401(k): a traditional pension, supplemented by a 401(k) plan. (Public employees use 403(b) or 457 plans.)[6]

Notes

[1] Loftus, Tom, and Morgan Watkins, “Kentucky Supreme Court: How Does a Sewer Bill Become Pension Reform?” Courier Journal, September 20, 2018, https://www.courier-journal.com/story/news/politics/2018/09/20/kentucky-pension-reform-supreme-court-hears-arguments/1344378002/

[2] MarketWatch, Wells Fargo Retirement Study: A Few Years Make a Big Difference, October 22, 2015, https://www.marketwatch.com/press-release/wells-fargo-retirement-study-a-few-years-makes-a-big-difference-2015-10-22?TB_iframe=true&width=370.8&height=658.8

[3] Ambrose, Eileen, “The 401(k) Turns 30,” Baltimore Sun, March 6, 2011, http://articles.baltimoresun.com/2011-03-06/business/bs-bz-ambrose-401k-20110306_1_ted-benna-savings-plan-retirement

[4] Taddonio, Patrice, “Watch: In Kentucky, Sewers, Pensions and Protests, Frontline, October 23, 2018, https://www.pbs.org/wgbh/frontline/article/watch-in-kentucky-sewers-pensions-and-protests/

[5] Walczak, Jared, “Tax Reform Moves to the States: State Revenue Implications and Reform Opportunities Following Federal Tax Reform,” Tax Foundation, https://taxfoundation.org/state-conformity-federal-tax-reform/

[6] Tong, Scott, “Father of Modern 401(k) Says it Fails Many Americans,” Marketplace, June 13, 2013, https://www.marketplace.org/2013/06/13/sustainability/consumed/father-modern-401k-says-it-fails-many-americans

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