Congressional Republicans are preparing to advocate for reduced tax rates. But what’s the method for funding these reductions? One potential option: imposing taxes on retirement savings at the time of contribution.
Many in the retirement savings sector are concerned that legislators may choose to “Rothify” some or all contributions made to employees’ 401(k) plans.
Currently, contributions to a traditional 401(k) account are not taxed at the time of deposit. The investments then grow tax-deferred, but withdrawals taken during retirement are taxed as ordinary income.
In contrast, Roth 401(k)s and Roth IRAs operate differently. In a Roth account, contributions are made with after-tax dollars, allowing for tax-free growth and withdrawals later on.
Should lawmakers choose to “Rothify” 401(k) plans, they could consider all or some future contributions as taxable income in the year those contributions are made.
Related: Tax reform could eliminate certain deductions
This concept isn’t novel. A similar proposal was included in Dave Camp’s 2014 tax reform initiative, who was the then-chairman of the House Ways and Means Committee.
According to Camp’s plan, individuals would be allowed to make pre-tax contributions of up to half of the annual contribution limit, which for this year is $18,000. Additionally, any employer matching contributions would also be pre-tax. However, any additional contributions made by employees would be taxed immediately.
By front-loading taxes on long-term savings, Rothifying 401(k)s has the potential to generate short-term revenue — Camp’s proposal was projected to yield nearly $144 billion over ten years. This could help offset the costs of the permanent tax cuts that Republicans desire.
Nevertheless, this change could result in a revenue loss over time since the federal government would receive less tax income when retired employees begin making tax-free withdrawals.
Critics, such as the Committee for a Responsible Federal Budget, view this timing shift as a fiscal maneuver, stating, “It produces savings in the immediate term by deferring costs into the long term.
So, would this be advantageous or disadvantageous for retirement savers? The answer remains uncertain.
“There’s a noticeable lack of research concerning how employees and employers might respond,” noted Nevin Adams, communications chief for the American Retirement Association, in a recent blog entry.
This is set to change soon, as the Employee Benefit Research Institute is examining the impacts that Rothification could have on retirement results.
Meanwhile, insights from the industry show that a significant majority of the 400 employer-sponsored plan providers surveyed by the Plan Sponsor Council of America believe that Rothifying 401(k)s would be unwise, advocating for maximum flexibility for employers to tailor their savings plans to meet the needs of their staff.
The PSCA is part of the newly established Save Our Savings Coalition, which consists of plan providers, trade organizations, and nonprofit organizations focused on savings education. Coalition members are concerned that Rothifying might discourage individuals from saving at levels comparable to the existing system.
Presently, numerous employers already provide a Roth option to their employees. For example, at Empower Retirement, the nation’s second largest plan provider, approximately half of its 37,000 clients offer such an option.
Overall, around three-quarters of employer-sponsored plans feature a Roth component, according to the PSCA. However, employee participation rates in Roth accounts remain quite low.
“When given the option, American workers largely prefer traditional accounts to Roth accounts,” stated Jim McCrery, a former leading Republican on the Ways and Means Committee, who now leads the Save Our Savings Coalition. “Limiting access to tax-deferred retirement savings merely to increase revenue could likely diminish the amount people save, thus endangering the financial well-being of future retirees.”
Conversely, Camp estimated that only 17% of workers contributing to 401(k)s would be impacted by his proposal, as most people do not contribute more than half of the permissible annual limit.
What remains clear is that encouraging Americans to save adequately for retirement continues to pose a significant challenge.
Correction: The initial article referred to PSCA as the Profit Sharing Council of America. That name has since been updated to the Plan Sponsor Council of America.
