What ‘Rothifying’ 401(k)s Would Mean for Retirees

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Taken from an article in the Wall Street Journal.

One idea that gets dis­cussed is to re­peal the cur­rent struc­ture of pre­tax con­tri­bu­tions to re­tire­ment ac­counts in fa­vor of a sys­tem where con­tri­bu­tions would come only from af­ter-tax in­come—as con­tri­bu­tions to Roth IRAs do now. It’s an idea, called Roth­ifi­ca­tion, that has been cham­pi­oned at times in the past. But it could be given new life by the gov­ern­ment’s cur­rent enor­mous need for rev­enue to plug bud­get gaps and rein in the na­tion’s debt.

Given that pos­si­bil­ity, we wanted to ask the ques­tion: How would such a sys­tem af­fect work­ers sav­ing for re­tire­ment? The short an­swer: poorly.

To ex­plain, let’s be clearer about what the change would en­tail. Right now, most U.S. savers con­tribute to re­tire­ment ac­counts with money that’s de­ducted from their tax­able in­come, and pay taxes on those ac­counts only when the money is paid out in re­tire­ment. The ra­tio­nale for this ap­proach to sav­ing in 401(k), 403(b) and in­di­vid­ual re­tire­ment ac­counts is that the tax pro­tec­tion those ac­counts pro­vide gives em­ploy­ees an in­cen­tive to set aside money for their golden years. The as­sets in de­fined-con­tri­bu­tion plans and IRAs hit $18.3 tril­lion as of the third quar­ter of 2019, ac­cord­ing to the In­vest­ment Com­pany In­sti­tute.

So, Why does this system need to be overhauled?

For one thing, the fed­eral deficit has bal­looned to more than $1 tril­lion in the cur­rent fis­cal year, while the fed­eral debt has hit $23 tril­lion, ac­cord­ing to the U.S. Trea­sury. And we have an ad­di­tional $43 tril­lion in So­cial Se­cu­rity un­der­fund­ing, ac­cord­ing to the 2019 re­port of the So­cial Se­cu­rity and Medicare trustees. Amid this tsunami of gov­ern­ment red ink, the Trea­sury es­ti­mates it will forgo $2.4 tril­lion in tax rev­enue on the na­tion’s tax-de­ferred re­tire­ment sav­ings over the next decade.

Un­der Roth­ifi­ca­tion, re­tire­ment con­tri­butions would come from af­ter-tax in­come and savers would pay no ad­di­tional in­come tax on in­vest­ment re­turns or on with­drawals in re­tire­ment. In­stead of the Trea­sury de­lay­ing the col­lec­tion of sub­stan­tial tax rev­enue un­til re­tirees with­draw money from their ac­counts, it would get its money now.

One thing is clear: The new sys­tem would im­pose dif­fer­ent tax bur­dens on low-paid work­ers and higher-wage work­ers. Dur­ing their work­ing lives, the lack of a tax de­fer­ment for re­tire­ment sav­ings would re­sult in a big­ger tax hit for work­ers in higher tax brack­ets than for those who make less. But in re­tire­ment, higher-paid work­ers would ben­e­fit more on the tax front, since they tend to make larger withdrawals from re­tire­ment ac­counts.

Be­yond those ef­fects, there is lit­tle ev­i­dence from ex­pe­ri­ence to help us pre­dict how Roth­ifi­ca­tion could af­fect work­ers. So we’ve built a de­tailed eco­nomic model to help us un­der­stand the po­ten­tial im­pacts of such a re­form. Here’s what the model pre­dicts:

  • In the Roth world, peo­ple’s life­time work hours would de­cline slightly. That’s be­cause con­tri­bu­tions to re­tire­ment ac­counts wouldn’t re­duce in­come taxes, so af­ter-tax salaries would be lower. That would prompt some peo­ple to work more to make up for the lost in­come, but our re­search sug­gests that more peo­ple would work less be­cause their time at work would be less valu­able.
  • Un­der a Roth regime, work­ers would claim So­cial Se­cu­rity ben­e­fits a year later on av­er­age. Cur­rently, since re­tirees pay in­come taxes on their 401(k) with­drawals, with­draw­ing more in or­der to de­lay claim­ing So­cial Se­cu­rity ben­e­fits and ul­ti­mately re­ceive a higher pay­out from the gov­ern­ment must be weighed against those taxes. This trade-off has to ac­count for the fact that only a por­tion of So­cial Se­cu­rity ben­e­fits are in­cluded in tax­able in­come—up to half could be tax-free.

But such com­plex tax con­sid­er­a­tions would be­come ir­rel­e­vant un­der a Roth regime, since with­drawals wouldn’t be taxed. Work­ers would be more likely to de­fer their So­cial Se­cu­rity ben­e­fits to boost the amount—es­pe­cially higher-paid work­ers, who would have more in their re­tire­ment ac­counts to cover their ex­penses while wait­ing to take So­cial Se­cu­rity.

  • Over their life­times, work­ers would ac­cu­mu­late one-third less in their 401(k)s un­der a Roth sys­tem. This is be­cause, with no tax ad­van­tage from con­tribut­ing to a 401(k), work­ers would save less and those lower con­tri­bu­tions would earn less over the years.
  • Life­time tax rev­enue gen­er­ated by the av­er­age worker un­der a Roth regime would fall 6% to 10%, com­pared with the cur­rent regime. This is be­cause peo­ple con­tribute and ac­cu­mu­late much more in their re­tire­ment ac­counts cur­rently than they would un­der Roth­ifi­ca­tion. The taxes col­lected on with­drawals of that money ex­ceed the amount of ad­di­tional in­come taxes that would be col­lected dur­ing peo­ple’s work­ing lives un­der Roth­ifi­cation.

Bot­tom line: Switch­ing to a sys­tem where con­tri­bu­tions to re­tire­ment ac­counts are made only with af­ter-tax money would boost tax rev­enue in the near term, but not as much as it would re­duce it in the longer term. And it would leave re­tirees worse off.

Dr. Mitchell is a pro­fes­sor of busi­ness eco­nomics/pol­icy and di­rec­tor of the Pen­sion Re­search Coun­cil at the Whar­ton School of the Uni­ver­sity of Penn­syl­va­nia. Dr. Mau­rer is a pro­fes­sor of fi­nance at Goethe Uni­ver­sity of Frank­furt. They can be reached at re­ports@wsj.-com.


R. LaMont W.

Robert L Woods

Robert L Woods

I am a personal finance and investment educator who’s passion is to teach financial literacy to my community to give them financial empowerment so they can control their own destiny.

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About Me

Robert L. Woods is the retired partner of the Institute For Fiduciary Education (www.ifecorp.com) that provided investment seminars for public and private pension funds, endowments and institutional fund managers. He spent 28 years working for the State of California, as a budget and financial analyst which includes 16 years as an Investment Officer for the California State Teachers’ Retirement System (CalSTRS). At CalSTRS, he established it as one of the nation’s first institutional home loan programs with a down payment assistance component. He also spent 13 years on the Board of Trustees for the Sacramento County Employees Retirement System (SCERS). He was a Trustee with the University of California, Davis, Cal Aggie Alumni Association and a member of the Chancellor’s Council on Community & Diversity. He is a Life Member: Phi Beta Sigma Fraternity, Inc., Theta Gamma Sigma Chapter, Sacramento, CA.

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