Dodged a Bullet? “Rothification” Likely to Reduce Retirement Saving

As part of its tax reform effort, the Congress was considering a proposal to require that employee contributions to 401(k)s above $2,400 go to a Roth – rather than a traditional – account. While this change is not currently in either the House or Senate bill, the debate over the tax plan is continuing. And opposition to other provisions – such as curtailing deductions for state and local taxes – could lead lawmakers to reconsider the 401(k) changes in order to help offset the overall cost of the tax-cut package. “Rothification” would help finance proposed tax cuts because it would increase government revenues over the next 10 years – the budget window for evaluating the impact of tax reform – and reduce revenues by a comparable amount thereafter. The increase occurs in the short term because money going to Roths is taxed up front, while taxation of money contributed to traditional plans does not occur until retirement. This effect on the budget is the sole reason that Rothification has been under consideration. The question is whether a shift to Roth accounts should be viewed as merely a budget gimmick or as a change that could affect how much people save for retirement. That subject is the focus of this brief. The discussion proceeds as follows. The first section describes the differences between Roth and traditional accounts. The second section discusses how switching to Roth accounts would affect the federal budget. The third section explores how the change may affect saving by different types of individuals. The final section concludes that Rothification is likely to lead to less saving by low- and moderate-earners who cannot afford to pay the taxes up-front. Among higher earners, savings may well remain unchanged, or even increase. Importantly, this budget-driven exercise is a diversion from real reform that would enhance retirement saving, such as mandatory auto-enrollment in 401(k)s, mandatory auto-escalation in the default contribution rate, automatic draw-down provisions, and an expansion of coverage to the half of private sector workers without a workplace retirement plan.