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Retirement Planning > Saving for Retirement

Would ‘Rothification’ of 401(k)s Crush Retirement Savings?

By Nick Thornton

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As the Trump administration and lawmakers consider amending the treatment of qualified retirement savings contributions to fund tax reform, they will have to reckon the impact that would have on savings rates.

They’ll be doing so with limited data on how “Rothification” would affect the $7.3 trillion defined contribution market.

Lawmakers are reportedly considering moving all or some portion of the defined contribution market to a Roth, or after-tax model, to bring tax revenues into the 10-year budget window.

Many in the retirement industry fear that would put downward pressure on savings rates at a time when the country is often described as being in a retirement crisis.

On the one hand, lower marginal rates that result in higher take-home pay could offset the benefit of tax-preferences on 401(k) and other defined contribution deferrals, which individuals can deduct from their taxable income.

On the other hand, some policy experts say it is conceivable that tax reform could actually bump some savers into a higher tax bracket. Other lower-wage earners may not see their marginal rate impacted by reform.

Those possibilities raise the question as to whether or not the existing tax incentives for retirement savings provide greater tax relief than lower rates, at least for some Americans.

“We just don’t know enough about what is being proposed, nor can we predict the future,” said Jack Towarnicky, executive director of the Plan Sponsor Council of America.

“It is impossible to say who is going to be a net tax winner and a net tax loser as a result of the changes,” added Towarnicky.

The PSCA, an advocate for employer sponsors of retirement savings plans, is part of the Save Our Savings Coalition, formed this year to lobby to preserve the existing tax treatment of retirement savings plans. The SOS Coalition includes AARP, employer advocates, benefits consultants, and asset managers.

A recent study published in the Harvard Business Review showed plan participants contributed to traditional 401(k) plans and Roth plans at equal rates. Other data from record-keeper Alight Solutions—formerly Aon Hewitt—shows participants actually increased savings rates when they migrated to Roth 401(k)s.

But those studies may not provide sufficient evidence of how Rothification under tax reform would impact overall savings rates.

“They were only able to study the impact of Roth on a voluntary basis, and the Roth option is likely limited to individuals who have sufficient resources to continue the same 401(k) contribution rate and lose the tax exemption,” Jack VanDerhei, research director at the Employee Benefit Research Institute, recently told BenefitsPRO.

“Those individuals most likely to be subject to a budget constraint under a Roth system may not be in the data,” added VanDerhei, referring to the Harvard study. EBRI, which the SOS lists as an educational partner, is scheduled to release a study assessing how Roth savings impact lower wage earners.

Best evidence may be found in history of IRAs

The PSCA’s Towarnicky acknowledges that predicting participant and sponsor behaviors under a Roth-based retirement system is difficult—if not impossible.

While there is no existing experience of mandated Roth contributions to draw from, he says ample evidence can be found in the history of IRAs, and how contribution levels were impacted when Congress adjusted the tax treatment on individual accounts.

Since Congress created the traditional IRA in 1974, lawmakers have changed contribution caps several times. In 1981, lawmakers expanded access to IRAs, in an effort to stimulate retirement savings.

The “universal” IRA allowed taxpayers who were enrolled in employer savings plans to also make tax-deductible contributions to IRAs. The original IRA was only available to savers without access to a workplace plan.

Under universal IRAs, contributions skyrocketed to levels not seen since.

According to the Investment Company Institute, contributions went from $4.8 billion to $28.3 billion in the year after Congress expanded access. They hit $38.2 billion in 1985, and $37.8 billion in 1986.

But the gains were short-lived. With the tax reform bill passed in 1986, Congress eliminated universal IRAs as one way to offset lower individual tax rates. Only savers under an income threshold could save in both employer plans and IRAs.

The impact on contribution rates to IRAs was immediate and lasting. In 1987, contributions dropped to $14.1 billion. They continued to fall through 2001, when contributions were $7.4 billion.

Towarnicky thinks the experience of tax reform in 1986 provides the best, and perhaps only evidence of what could come under Rothification and 401(k) contributions.

“We have little experience with comparable changes to the tax treatment of retirement savings,” he said. “Our one example is disconcerting.”

The White House has said it expects to release a first view of tax reform on September 25. Treasury Secretary Steven Mnuchin has vowed to have legislation passed by the end of the year.

That would be a considerable accomplishment. Tax reform in 1986 was the culmination of more than two years horse-trading between Capitol Hill and the Regan White House.

“Something as complicated as the tax system is going to require a considerable amount of analysis,” said Towarnicky, who is among a long list of policy experts across industries that doubt Congress can meet the White House’s timetable.

He said lawmakers shouldn’t overlook the impact tax reform in 1986 had on IRA contributions.

“Hopefully those facts won’t get swept under the rug,” said Towarnicky.

— Check out Required Minimum Distributions and an Account Holder’s Death on ThinkAdvisor.

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