A little-noticed provision in the tax-reform bill passed by the House last month would disrupt the retirement plans of many school employees and could encourage veteran teachers to retire early to beat the rule’s effective date, state pension officials say.
Under the provision, retirees who contributed to their own pensions--as required in 47 state retirement systems--would lose the tax holiday on pension benefits now allowed during the first years of retirement. If the House version of the bill becomes law, the change would take effect July 1.
See related stories on pages 12, 19.
The new rule--a “sleeper” issue largely overlooked by education lobbyists--would “destroy maybe a whole career of tax planning,” said Dennis Ducker, assistant director for retirement systems in the North Carolina treasury department.
“We think it’s unfair. They should at least phase in a change like that,” said Victor Miller, an administrator with the Ohio teachers’ retirement system and secretary of the National Conference of Public Employee Retirement Systems.
Though the legislation’s impact would vary, an average middle-income retiree belonging to a contributory pension system would face an unexpected tax bite of $2,000 to $4,000 annually during the first years of retirement, according to estimates.
The new pension provision would raise more than $8 billion in revenue from retired federal, state, and local government employees over the next five years, according to the Congressional Joint Committee on Taxation.
Lobbyists for the American Federation of Teachers and the National Education Association will push for elimination of the provision when the Senate Finance Committee begins work on tax reform early next month.
Because of the substantial federal revenue that would result from the change, however, some observers say the chances are slim that the Senate will drop the provision.
Loss of Tax-Free ‘Window’
Under current law, new retirees receiving benefits under contributory systems enjoy a tax exemption on their pension income for up to 36 months, or until their withdrawals total what they paid into the system. The rationale is that these contributions, generally paid from after-tax earnings, should not be taxed twice.
The House bill, while preserving this exemption, would apportion it over a retiree’s expected lifetime, rather than lumping it together at the start of retirement. For example, a worker retiring at age 65 and projected by actuarial tables to live another 10 years would receive one-tenth of the tax exemption each year, instead of 100 percent in the first 18 to 36 months.
Currently, many retirees use the tax-free “window” period to receive other taxable income while remaining in a low tax bracket. Some retirees, for example, withdraw tax-deferred funds from an individual 4retirement account or a 403-(b) or 401-(k) savings plan, collect bonuses or deferred compensation in a lump sum, or continue working part time. This flexibility would be lost under the House legislation, pension officials contend.
“A large number of educators buy tax-sheltered annuities that they cash in during that three-year exclusionary period,” said Bruce W. Hineman of the Texas teachers’ retirement system and secretary-treasurer of the National Council on Teacher Retirement. The House-passed bill ''would almost render those 403-(b) [plans] useless,” he predicted.
“They’d lose their tax advantage,” Mr. Hineman said. “That, to me, is the worst damage.”
“I just despise the government always changing the rules on people retiring,” he added.
But Donald S. Grubbs, a consulting actuary to government and corporate pension systems, predicted the effect would be minimal. “Most people don’t do tax planning,” he said.
Overall, the House bill would cut tax rates for individuals, making ''the ordinary pensioner substantially better off,” Mr. Grubbs said.
At the same time, however, the new rule on contributory pensions could push a new retiree’s income into a higher-than-expected bracket. This would be especially costly under the proposed tax schedule, which replaces a set of 14 brackets with only four: 15 percent, 25 percent, 35 percent, and 38 percent.
In addition, the rule change could result in a new tax liability on Social Security benefits, for which many state and local employees are eligible. Under current law, if one-half of these benefits, added to other taxable income, boosts the tax liability to $25,000 for a single retiree (or to $32,000 for a married couple), one-half of the Social Security income becomes taxable.
The impact of the change on individuals would vary considerably, depending on the contribution and benefit formulas used by an employee’s pension system and on his or her financial situation.
In the long run, the change might mean a total tax bill no higher than that under current law, especially for low-income retirees (unless high inflation rates devalue the tax credit over the years). On the other hand, a pensioner who died earlier than projected would be penalized, compared with one who reached his or her actuarial life expectancy.
Hastening Retirements
In addition to the House provision’s effects on individual school employees, concerns have been raised that the new rule would encourage large numbers of teachers to retire before it takes effect, creating or exacerbating teacher shortages in some areas. Because of demographic patterns, a large number of teachers are expected to retire over the next five years nationwide--between 30 and 40 percent of all current teachers, according to a recent nea estimate.
In North Carolina, for example, Mr. Ducker of the state retirement system noted that about 7,000 of the state’s 60,000 teachers are currently eligible for full pensions and 20,000 for early retirement. The new rule may prompt such teachers to end their careers prematurely to avoid its effects, he said. Mr. Miller of Ohio echoed that concern.
On the other hand, Mr. Hineman of the nctr predicted that this trend would be limited to those anticipating a substantial tax bite in the early years of retirement.
As passed by the House, the change would affect anyone whose annuity begins after July 1, a date that could encourage retirements after the current school year.
But Capitol Hill sources said that if the provision becomes law, the Congress is likely to make it effective no earlier than Jan. 1, 1987, thereby allowing its own retiring members--such as Speaker of the House Thomas P. O’Neill Jr.--to escape the consequences. The House has passed a nonbinding resolution expressing a preference for a later effective date.
Overlooked by Lobbyists
The proposal for the new treatment of pensions attracted little attention from lobbyists earlier this year, when it surfaced in the Reagan Administration’s “Treasury II” tax-reform package. Associations representing school employees and other government workers were caught unaware when the “sleeper” was tentatively approved by the House Ways and Means Committee Nov. 6.
Public-employee organizations’ efforts on the bill were largely focused on the successful campaign to retain the deductibility of state and local taxes. That issue will remain “the number-one priority” for the aft as the tax-reform battle moves to the Senate, according to Gregory A. Humphrey, a lobbyist for the union.
But the aft also plans an effort to eliminate the new pension provision, Mr. Humphrey said, although he declined to predict the outcome.
“There are 22 [Senate] Republicans up for re-election, and they’ll be submitting every conceivable amendment from every conceivable special-interest group,” he said.
The nea plans to place a higher priority on the pension issue as well, according to its chief lobbyist, Dale Lestina.
A Republican version of tax reform, incorporating an amendment sponsored by Representative Frank Wolf, Republican of Virginia, would have preserved current law on the taxation of contributory pensions. This minority substitute failed to pass in the House, but one lobbyist for a group of federal senior executives predicted it could help persuade the Republican-controlled Senate to reject the House provision.
Other Capitol Hill sources, however, said the pension tax is tempting to lawmakers, because public employees are considered a weaker constituency than many others. That means, those sources say, that the new rule would raise substantial revenues with minimal political pain.
