In-Depth: What Hath Roth Wrought?

The forced ‘Rothification’ of defined contribution plans would be a disaster, say industry experts.

In Congress’ latest endeavor to tackle tax reform, there are some on Capitol Hill who have floated the possibility of the “Rothification” of defined contribution plans to help pay for the promised corporate tax cuts, or at least to create the appearance of paying for them.

But many tax experts and fund administrators say such a move would be detrimental to millions of Americans’ retirement savings plans.

Because traditional IRAs are tax free when the money is put in, while Roth IRAs are not, the idea is that the taxes that workers would have to pay when contributing to their defined contribution plans would create a new revenue stream for the government to help cover the cost of the tax cuts.

An ‘Unmitigated Disaster’

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Requiring everyone who has a 401(k) plan to transfer over to a Roth version would likely create chaos for defined contribution fund administrators, and confusion and irritation for the participants, which would inevitably lead to reduced retirement savings, experts say.

“To require people to transfer to a Roth and have it taxable would be an unmitigated disaster,” Dean Zerbe, former tax counsel to the US Senate Committee on Finance, said in an interview with CIO.  Zerbe, who is now national managing director of the tax consulting firm Alliantgroup, said the paperwork alone for participants would have them cursing Congress. “I think it would be bad policy all around.”

However, the main concern is the knock-on effect that paperwork will lead to. Dennis Simmons, the executive director of the Committee on Investment of Employee Benefit Assets (CIEBA), which represents more than 100 of the US’ largest pension funds, said his main fear is that it will cause many workers to simply forgo participating in a retirement savings plan.

“We think it, at a minimum, throws a huge question mark into a system that, by all accounts, is working well,” Simmons told CIO. “To change things would reduce savings, and there will be people who either drop their percentages, or get out of the 401(k) plan completely.”

In a survey of CIEBA members on a potential shift from pre-tax 401(k) deferrals to Roth deferrals, 78% of respondents said a switch to an all-Roth system would negatively affect participation rates in their 401(k) plans, and more than 82% said their participants would view a change to a Roth-only system negatively. Meanwhile, 61% of CIEBA members surveyed said they would not be comfortable converting their participants of pre-tax deferral plans into participants who make Roth deferrals without getting their consent.

The survey also found that when both options were available, CIEBA member participants overwhelmingly chose a traditional plan to a Roth. It found that approximately 90% of the dollars deferred into CIEBA members’ 401(k) plans were made through traditional pre-tax deferrals instead of Roth deferrals.

“The big concern is that if savers today find out they have to pay tax on it, they will say ‘I’m out,’” said Simmons.

A Squeeze on Retirement Savings

Reducing the tax incentives for workplace retirement plans “could jeopardize the retirement security of these Americans and add to the challenge of maintaining adequate income for future generations of retirees,” according to a recent white paper from consulting firm Mercer.

The firm said that although tax incentives may not be as strong an influence on participants’ savings behavior as employer matching contributions are, they appear to encourage those who don’t have access to a match to save.

“We, along with plan sponsors, are very concerned that changes to the tax incentives could damage participant savings rates,” said Mercer in its white paper. “These concerns also hold true with respect to proposals to require some or all contributions to retirement plans to be made on an after-tax basis similar to Roth IRAs, rather than on a pre-tax basis.” Mercer added that “such proposals could lower overall savings levels, increase in-service withdrawals, and diminish smaller employers’ willingness to sponsor plans.”

Simmons also said the average defined contribution plan participant wouldn’t understand the move, and that it would be a huge effort to educate them and encourage them to save, adding that it had been a chore to get people to sign up for a plan before automatic enrollment.

Real Revenue vs. ‘Washington Revenue’

Bailing out of their 401(k) plans would not only make it more difficult for workers to save for retirement, but it would hurt the intended reason for the switch by producing a smaller-than-anticipated tax revenue stream to pay for the tax cuts. Although Simmons contends that the very idea that “Rothification” would create a revenue stream is bogus. He said switching people to Roth plans wouldn’t generate real revenue, but would generate what he called “Washington revenue” over the next 10 years.

“It is only supported just to try to make budget math work,” said Simmons, “and it doesn’t do that in the long run because it loses the revenue on Roth on the back end.”

According to the Mercer white paper, tax incentives for retirement plans are not a complete revenue loss, but are a deferral of taxable income, and are treated as tax “expenditures” for the purposes of budget scoring.

“However, at the time of retirement, deferred amounts and the investment income earned on them are withdrawn and taxed at normal income tax rates,” said Mercer. “Therefore, retirement incentives are not truly tax expenditures, and are often recouped outside of the congressional 10-year budget window.”

Nevertheless, a January report from Congress’ Joint Committee on Taxation (JCT) gave lawmakers a reason to think that Rothification offered real, and significant, revenue. The report estimated that between 2016 and 2020, the tax deferral from defined contribution plans could cost the federal government $583.6 billion.

“Such a figure represents a tempting amount of revenue that policymakers could seek to recoup through Rothification,” wrote Amir El-Sibaie, an analyst at tax policy nonprofit group the Tax Foundation, in a September 12 article.  In his article, El-Sibaie quoted Michael Kreps, a former senior pensions and employment counsel for the Senate Health, Education, Labor, and Pensions Committee, as saying that the threat of Rothification “is real, and we should all be taking it seriously.”

However, since that time, Kreps said he has become less concerned about the imminent threat of Rothification, although he added that it should not yet be dismissed.

“It is very positive that neither the bill passed by the House, nor the bill approved by the Senate Finance Committee includes Rothification,” Kreps told CIO. “It is important to continue to monitor the legislation as it moves forward, but I have been heartened by the fact that members of Congress on both sides of the aisle recognize the importance of the tax incentive for retirement savings.”


A Possible Solution

Zerbe has his own ideas on how the tax bill could include corporate tax cuts, while also benefiting retirement savings plans. He suggests making the tax cuts performance-based by tying them to companies that meet certain standards or enact policies that help their employees save.

“Personally, I had wanted the corporate tax cut to be tied to companies that fully fund their pensions, and/or do a full match on IRAs, or do employee profit sharing or ownership,” said Zerbe.

Despite Zerbe’s concerns over how damaging “Rothification” could be, he said he doesn’t think the concept is going anywhere on Capitol Hill, and doesn’t believe it will end up as part of the final tax reform bill. In fact, he said that depending on how things go in the Dec. 12 US Senate special election in Alabama, there may be no tax bill at all.

“I think the Alabama election matters a lot, too, if they get down to a one-seat margin … another seat loss would start putting some rocks in their paths,” he said, adding that “there’s now a lot of uncertainty over how that election will go … I think it could have real impact on the tax debate.”

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