What Now for Rothification? 401(k)s Are Safe for Now, but the Story Isn’t Over

The debate over the tax-preferred treatment of retirement plans shows that some lawmakers do favor limiting pretax contributions

Maybe it’s not quite yet a household word.

But without a doubt, more savers in workplace retirement plans have now at least heard the word "Rothification," a term coined in the months-long run-up to the release of the GOP’s tax bill last week.

Belying months of speculation, Republicans were able to advance tax cuts and stay within budget parameters without using deferrals to traditional 401(k)s and IRAs as revenue offsets. Not only were 401(k) contributions spared, but so was the largest expenditure in the tax code — employer-provided health care plans.

Advocates for plan sponsors and the financial services industry proved more powerful than the realtor and home building industries, which are pushing back against the GOP bill’s new limits on mortgage interest deductions, and a new cap on the deductibility of property taxes.

House Republicans and the White House have said the deduction on mortgage interest would be spared for more than a year.

Even the top GOP tax writer has said the proposed bill will be revised considerably by the time it is moved to the Senate.

While nothing is guaranteed, no one seems to be predicting that 401(k) contributions will reappear as a revenue-raising option.

At least for now. But one 401(k) plan consultant thinks plan sponsors need to add after-tax, or Roth savings options to participants, in the event that Rothification reemerges during budget debates in coming years.

“When we think about all the interest that has been generated from the tax discussion, and all the conversation about Rothification, it leads us to believe we haven’t seen the end of it yet,” said Marina Edwards, a senior consultant at Willis Towers Watson.

Edwards underscores she is not making a thinly veiled prediction as to what can be expected as the reform bill is marked up in the House, and whether fiscal hawks in the Senate will insist on reform being deficit neutral.

But what the debate over the tax-preferred treatment of 401(k)s has shown is that there are lawmakers that favor limiting pretax contributions.

“It’s such a big pot of money,” Edwards said, referring to the postponed revenues the Treasury Department collects on traditional 401(k)s when assets are withdrawn and taxed in retirement. The most recent numbers from Treasury show that pretax contributions to traditional 401(k)s will account for more than $1 trillion in tax expenditures between 2018 and 2027.

“The ideas generated from this pass of legislation may be leading indicators of what is to come,” said Edwards. “There are clearly some legislative supporters for Rothification.”

That’s why plans sponsors who don’t offer a Roth savings option would be wise to consider doing so immediately.

According to the Plan Sponsor Council of America, about 58% of 401(k) plans include a Roth savings option. That drops to 53% for the largest plans.

Since the Pension Protection Act of 2006 made Roth 401(k)s permanent, take-up rates have increased, but are still low—less than 20% of participants save after-tax dollars for all plan sizes.

Edwards’ argument for wider Roth adoption is two-fold. On the one hand, it would make life much easier for sponsors if indeed Rothification reemerges as a policy option in coming years.

“Imagine if Rothification had come through with the reform bill,” said Edwards. “You would have sponsors that don’t offer a Roth option scrambling to put this in place.”

The second argument is one that Congress likely won’t vet in the coming weeks: that Roth savings are the right option for many savers.

“We know that for a lot of participants, Roth isn’t a bad thing,” said Edwards. “But most participants are still 100% pretax.”

Plan education efforts have been successful in preaching the need to diversify 401(k) portfolios—QDIAs like target-date funds do that automatically.

Edwards thinks sponsors and plan providers need to evolve platforms to include diversification of tax exposure in retirement. Spreading savings across traditional 401(k)s and Roth 401(k)s can be a productive way to hedge tax exposure risk in retirement, she says.

“Why wouldn’t we apply the logic of asset diversification to tax diversification,” asks Edwards.

In fact, Edwards says that is already being done.

“Should you be investing in a Roth — that’s a conversation we are having with our plan participants today,” explained Edwards.

Increasingly sophisticated analytic and modeling tools can show where a diversified portfolio — say half in a traditional 401(k), and half in a Roth account — can improve retirement income outcomes.

“Those tools are beginning to crop up all over. Record keepers have modeling, and more plan consultants are using them,” she said.

Still, the industry and sponsors have a way to go.

“We have a lot more education to do on tax diversification,” said Edwards. “Industry has room to improve in how they are communicating to plan sponsors, and sponsors have room to improve in how they educate participants. The more we can educate, maybe we can get more participants to understand that Rothification is not such a bad idea.”

While asset mangers, plan sponsors, and consumer advocates are breathing a collective sigh of relief as the House prepares to mark up the tax bill next week, Edwards is confident that Rothification as a policy question will come up again.

“We’re not done with this conversation yet,” added Edwards. “If there is a sense that Rothification could again get legs with Congress, why wouldn’t you try to get ahead of it, so as not to leave participants in the lurch?”

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