Congress is considering a shift from pretax benefits for retirement accounts to after-tax, Roth-type plans in its tax reform efforts, warn retirement plan advocacy groups, such as the American Retirement Association and the American Benefits Council. The idea originally was floated by former House Ways and Means Committee Chairman Dave Camp (R-Mich.) in his 2014 tax reform proposal. The Trump Administration has given mixed signals with regard to its intention to change retirement plan tax benefits. Until legislative language is released, the fate of the hugely popular 401(k) model of retirement savings is uncertain. These 401(k) plans represented a $4.8 trillion market as of 2016, according to the Investment Company Institute.
How 401(k) Deductions Work
Tax-favored retirement plans, including IRAs and 401(k)s, come in two flavors, pre-tax and after-tax. In traditional, pre-tax plans, a taxpayer contributes pre-tax money to a plan, thereby reducing the taxpayer’s current-year income. This current deduction is a significant tax savings for taxpayers who are in their highest years of earnings. In addition, accumulated earnings in the account grow tax-free. So, taxpayers do not pay any tax on the account until the funds are withdrawn after retirement age, 59 ½, when presumably the taxpayer is in a lower bracket. (Note that there are penalties for early distribution.)
In Roth 401(k) and Roth IRA plans, the savings are at the back-end. Taxpayer do not get a current deduction for contributing to the plan, but earnings grow tax free and are never taxed at all if the taxpayer follows the rules and waits until 59 ½ to withdraw the accumulated income in the account. In traditional plans, earnings are eventually taxed when withdrawn.
If Congress eliminates current tax savings for retirement plans and “Rothifies” them, taxpayers would be currently taxed on contributions made by both employers and employees to a retirement plan. The tax savings on accumulated earnings would continue. In Roth-type plans, those earnings would be tax-free upon distribution.
Congress is eyeing the Rothification idea because changing from the current system with mostly pre-tax funding of retirement plans to a Roth system will raise substantial revenue. The Joint Committee on Taxation has estimated that defined contribution plans such as 401(k)s will cost the federal government $583.6 billion between 2016-2020. Traditional IRAs are estimated to cost $85.8 billion in foregone tax revenue over the same period.
Backlash Has Already Begun
Attempts to head off the change to retirement savings taxation are already well underway led by industry groups. “Proposals to raise money by reducing such incentives are short-sighted, producing only short-term deficit reduction and causing serious long-term damage to the retirement security of tens of millions of working Americans.” That assessment comes from an American Retirement Association statement on tax reform.
The ERISA Industry Committee echoes that sentiment: “A drastic shift to Roth contributions could undermine the entire retirement system in this country and undo the progress that has been made through widely favored pre-tax 401(k) plans.” Finally, the Employee Benefits Research Institute is undertaking a survey and research which will be published soon to show how “Rothification” could affect retirement savings in the U.S.
Despite the popularity of the current tax benefits for retirement savings, these provisions are vulnerable in any tax reform effort. Employers and employees should watch this issue carefully because of the potential dramatic change in personal financial planning that could result if Congress adopts “Rothification.”
About the Blogger
Lucia Nasuti Smeal is a guest blogger on tax topics for Frazier & Deeter. Smeal is an attorney, a tax Professor with Georgia State University’s J. Mack Robinson College of Business, and former editor of Tax Notes Today, published by Tax Analysts. Smeal also worked as a legislative analyst for the Congressional Research Service and is a former member of the U.S. House Periodical Press Corps. She is a frequent speaker on current tax developments.