Although the tax revenue impact of “Rothifying” section 401(k) plans remains murky, some observers say that the hundreds of billions of dollars in apparent revenue gains aren’t a sustainable way to pay for permanent tax cuts.
Shai Akabas of the Bipartisan Policy Center (BPC) told Tax Analysts that it would be a “clear loss to the federal government” over the long term if one-time, short-term revenue gains from converting 401(k)s to Roth plans are used to justify lowering tax rates permanently. Others agree that this approach would be unsustainable and that the picture created by the 10-year budget window would be misleading. Understanding the true revenue impact of Rothification requires looking beyond just five or 10 years and considering numerous variables, they say.
No official proposals have been introduced, but rumors have persisted that the GOP’s tax reform package could include a proposal to reduce or fully remove the pretax benefits of section 401(k) plans, commonly known as “Rothification.” Such proposals could appear more attractive now that the House Republicans’ controversial border-adjustable tax appears to have been scrapped. Industry advocates have warned that Rothification could harm retirees, and they are particularly concerned about how it could affect the saving behaviors of account holders.
What makes Rothification politically tempting is that it would seemingly raise hundreds of billions of dollars within a five- or 10-year budget window. The Joint Committee on Taxation’s most recent estimates of federal tax expenditures found that defined contribution plans, like section 401(k) plans, will account for $583.6 billion in lost tax revenue between 2016 and 2020. The Wall Street Journal has reported that the estimate over the next 10 years could be as high as $1.5 trillion.
Revenue Shift Can’t Pay for Cuts
However, those estimates paint a misleading picture, given that 401(k) plans are taxed upon withdrawal, which isn’t reflected by a short-term budget window. What the revenue picture looks like beyond that window depends on several variables, but there’s no reason to believe those massive revenue gains would continue, Akabas said.
Rothification should be thought of as a “timing shift of tax revenue that otherwise would have been collected in decades to come, that is instead collected in the budget window,” said Matthew Gardner of the Institute on Taxation and Economic Policy. He explained that while the budget rules may allow Congress to view it as a revenue raiser, it shouldn’t be thought of as a way to pay for permanent tax cuts. “You absolutely can’t count on this short-term revenue as a funding source for anything down the road,” he said. “It would be a dangerous mistake and an unsustainable strategy to use Rothification as a way of paying for our nation’s needs in the long run.” Steven M. Rosenthal of the Urban-Brookings Tax Policy Center agreed that it’s inappropriate to view Rothification as a genuine revenue raiser despite what the budget window might show.
Akabas said that if the budget window revenue gains from Rothification were used on some sort of short-term spending, such as infrastructure spending, then that might be a more fiscally sound approach. “But if it’s used to pay for something that goes on indefinitely, then it’s a clear loss for the government,” he said. “You’re creating a future expense that isn’t being paid for in some ongoing way.”
However, Ray Beeman of EY said using Rothification to help justify permanent tax cuts depends on how you view the overall virtues of tax reform. Beeman served as tax counsel for the House Ways and Means Committee and as an adviser to former committee chair Dave Camp on tax reform. “If you think tax reform is going to drive sufficient economic growth, then that would offset the revenue you may be losing statically on these kinds of provisions,” Beeman said, adding that the biggest driver of revenue is economic growth, and that it dwarfs the impacts of the tax policies being enacted.
Complicated Revenue Picture
Akabas said that while Rothification isn’t a fiscally responsible way to pay for permanent tax cuts, it’s difficult to say exactly how Rothification on its own will affect future tax revenue more generally.
“The most interesting thing that I’ve discovered is that it’s not exactly right to think about Rothification as pulling money from the future in a way that leaves a deficit for the next generation,” Akabas said. He said that while the current generation would begin paying taxes on contributions up front, thus forgoing tax revenue that would have been collected further down the road, successive generations would also be paying taxes on contributions, which would help fill in some of that lost future revenue. However, he explained that this won’t necessarily be an exact substitution, and that it’s difficult to predict how much future lost revenue would actually be made up.
“It’s not like we have a huge hole in exactly 20 years or 30 years from now when all of this money would have been removed that we’re moving up to today,” he said. “It’s a little more complicated than that.”
Rothification isn’t a new concept and future proposals might not call for going fully Roth. Camp’s 2014 tax reform proposal included a proposal under which contributions made in excess of one-half of the applicable IRS limit could no longer be made on a pretax basis, but instead would be treated as Roth contributions. The JCT estimated that the proposal — which Beeman referred to as going “half-Roth” — would raise about $144 billion over 10 years.
Beeman noted that one advantage of the half-Roth approach is the distributional benefit, specifically that the change wouldn’t affect many lower- and middle-income people because many of them aren’t contributing more than half of the maximum limit to begin with. A 2017 report on saving behavior by the Vanguard Group Inc. found that in 2016, only 10 percent of participants saved the statutory maximum of $18,000 for defined contribution plans.
Harvard University professor Brigitte Madrian believes Congress is more likely to embrace full Rothification, but agreed with Beeman that a Camp-style proposal would be less disruptive. Madrian — whose research focuses on household saving and investment behavior, including retirement plans — said that a half-Roth proposal “wouldn’t impact most people, because most people aren’t contributing anywhere near the maximum limit, but it would impact higher-income people who are contributing at the limit,” she said. “They’re also in higher tax brackets, so that’s another way to get more revenue today, but it’s a slightly more complicated approach.”
Better Way to Score?
The reason Rothification looks so lucrative on paper in the short term is the JCT’s cash-basis scoring approach, Akabas said. That approach overstates the cost of tax deferral for 401(k)s because the cost of the tax deferral is included in the budget window, but the revenue gained on withdrawals outside the budget window is not. Conversely, this method understates the cost of contributions to Roth accounts, because significant tax-free withdrawals occur outside the window.
The BPC has recommended a different scoring method known as “net present value” that it claims would create a more accurate picture of what Rothification of 401(k)s would cost the federal government. A net present value score would look both at the immediate fiscal cost of a policy and its cost in the future. It also discounts revenue received in the future to today’s dollars. “A more-accurate projection method might also discourage policymakers from pursuing policies that seem to achieve federal budget savings in the near term, but that are, in reality, likely to result in higher long-run deficits,” the BPC said in a June 2016 report.
The BPC has acknowledged that the net present value approach makes many assumptions, such as about future interest rates and the rate of earnings on assets. It also incorporates assumptions about how the saving habits of individuals will be affected by policy changes. But the BPC notes that the Congressional Budget Office and the JCT already make comparable assumptions for many of their estimates. Akabas noted that there’s precedent for using net present value when appropriate. In 1990, the Federal Credit Reform Act changed cost estimates for federal credit programs, such as federal student loans, from a cash basis to a net present value basis.
“There’s no question that we should be finding a way to look at a longer-term budget window,” Gardner said. “The fact that people are even considering going to the well on this particular gimmick reinforces the need for a more comprehensive way of scoring these provisions.”
Beeman noted that there are lots of things that are artificial about the budget rules and measuring tax revenue, including the 10-year window and the failure to use present values. He said that the budget rules also don’t account for overall growth, so there are limitations that cut both ways, but that lawmakers must work within the parameters they’ve been given. “The JCT estimators will tell you that with any effort to adhere to some concept of neutrality beyond 10 years, the estimating breaks down,” Beeman said.
The variable most likely to affect individual taxpayers under Rothification is how their tax brackets may differ between contribution and withdrawal. Rosenthal noted that the tax implications of 401(k)s versus Roth accounts are essentially a wash for individual account holders if one assumes that the tax rate they would pay on contributions under a Roth account is the same as the rate they would pay on withdrawals under a 401(k). If one also assumes that taxpayers would contribute less initially under a Roth system because they are forced to pay taxes on the contribution up front, then from a tax policy standpoint, it really wouldn’t make a difference if Congress wants to encourage people to use Roth plans instead of traditional 401(k)s.
Gardner agreed that the tax outcome for account holders might not be meaningfully affected by Rothification. “It wouldn’t dramatically restructure the fairness or the cost over the long haul,” he said.
Madrian said it’s true that under the assumption that rates wouldn’t vary, taxpayers wouldn’t be drastically affected, but she said it’s unclear if that assumption is fair. “We don’t really have any good evidence on that one way or the other,” she said. If account holders are paying taxes at a different rate when they retire than when they were contributing, the tax implications become more complicated, Madrian noted.
In a July 17 letter to Senate Finance Committee Chair Orrin G. Hatch, R-Utah, the American Benefits Council argued that under Rothification, “many individuals would be making contributions and paying tax at high tax brackets and then receive a tax break on distribution when they would be in a low tax bracket. This would be systematically inadvisable, undermining the incentive to contribute to a retirement plan.”
Madrian said there are sources of income in retirement, such as Social Security, that get favorable tax treatment, which reduces income and can shift taxpayers into a lower tax bracket. She also said that most elderly people are living on less income in retirement than they were when they were working, adjusting for inflation. “So those are the reasons people might have a lower tax rate in retirement and why they might be penalized if you moved everyone to a Roth system,” she said.
It’s difficult to predict what tax rate an individual will be paying in retirement in part because it’s impossible to predict what tax rates will look like in the future. Madrian said one argument for individuals to use Roth plans is that many believe tax rates will only rise in the future, in order to pay off the federal debt, so they would rather pay taxes now while rates are lower. Gardner said that given the complexities involved, there’s some value in giving taxpayers the flexibility to choose either pretax contributions or tax-free withdrawals, but that even choosing between those options can be too complicated for taxpayers.
Gardner said that scaling back retirement tax incentives could be a valuable part of tax reform that leads to sustainable revenue gains, but that the Rothification approach being discussed does nothing to reduce the cost of those expenditures over the long term. “There’s a real missed opportunity if Congress chooses to restructure retirement savings incentives in this way,” he said. “A much more sensible approach would be to ask whether these retirement tax breaks are working at all, and if they’re not, to find ways of targeting them better to middle- and low-income families.”