Barry’s Pickings Online: Roth-only?

Art by J.CardielloThere are widespread reports that House Republicans—in an effort to raise revenues for unrelated purposes—are considering converting the current 401(k) system to Roth-only contributions: requiring that all participant contributions be made on an after tax basis. Those contributions would then—under “Roth treatment”—accumulate and be paid out tax-free (subject, one assumes, to some sort of holding period requirement). Many are reacting (very) negatively to this idea, arguing that it will result in a significant reduction in retirement savings and that, particularly, an all-Roth system will discourage participants from making 401(k) contributions.

I’m finding the discussion of this a confusing mixture of cynicism and misunderstanding—or at least a lack-of-being-clear—all round. So I’d like to get some things straight about Roth versus non-Roth contributions and then discuss what seem to me to be the obvious problems with it.

Retirement savings taxation math 

So, first, I want to start with the math. Under the current “non-Roth” system, a participant can make a “pre-tax” contribution—say, the current $18,000 maximum—to a plan, leave it there for 15 years (or one year or 40 years). When this non-Roth saver takes her money out (contributions and earnings), she will pay taxes (at her then income tax rate) on the entire distribution. (That, by the way, will be the first time she has paid any taxes on this money.)

Under the Roth system, an identical participant can take an identical $18,000, pay taxes on it first (at her income tax rate in the year of contribution), then put the (after-tax) balance into the plan. When this Roth saver takes her money out after 15 years, she will take it (contributions and earnings) tax-free.

Can we all agree that—assuming that the tax rate for these savers is same at the time of distribution as it was at the time of contribution, and assuming that they both left the money in for the same period and earnings were identical—these two savers, at distribution, will both have the same amount of money, after taxes. That is, it doesn’t matter if you pay all your taxes at distribution, or you pay all of them at contribution. Your benefit is the same: the non-taxation of trust earnings.

Why do participants dislike Roth? 

Now, I have some significant problems with “Roth only,” which I’m going to get to. But something I find a little puzzling (and in some respects interesting) is that many are saying (and with some evidence) that participants (and particularly low-paid participants) don’t like Roth contributions. And, I thought we just agreed that it doesn’t affect participants.

Here are my thoughts about why that might be—that participants don’t like Roth contributions:

(1) Plans calculate contributions and matching contributions on the basis of gross (that is, pre-tax) pay. So that whole thing about starting with “the identical” $18,000, paying taxes on it, and contributing the balance doesn’t work. OK. But, isn’t there a way to fix that?

(2) Participants don’t understand the math. Maybe. But, again, can’t the math of this be explained?

(3) Most participants expect to be in a lower tax bracket when they take their money out, so that that assumption we made (that tax rates are constant) doesn’t hold. I actually think this may in fact be the case. I would certainly like to see more research on it. If all the talk we hear about how participants are not saving enough is the case, then it seems to me that such a participant expectation may be pretty rational: they will be paying taxes at a lower rate in retirement, because they will have less income in retirement.

Whatever the case, we are going to need to get some clarity on: participant attitudes toward Roth contributions; whether (if they are negative) they can be changed; and whether (if they are negative and can’t be changed) the adverse effect on retirement savings of a Roth-only regime is acceptable.

Those are my thoughts—at this point (and before we’ve seen any actual proposal)—on the effect of Roth-only on participants.

But I have three other problems with Roth-only. First, under the current system, taxpayers who believe their current tax rate is lower than it will be in the future can make a Roth contribution and, in effect, shift income from a (future) higher tax year to the (current) low tax year. And taxpayers who believe their current tax rate is higher than it will be in the future can make a non-Roth contribution and shift income from the (current) high tax year to a (future) low tax year.

In other words, the current system allows flexible income smoothing in both directions. That’s not really a retirement policy value—it’s an income tax policy value. And I think it is a really good thing, especially when you have a steeply progressive income tax. Getting rid of it—or, as Roth-only would do, only allowing smoothing in one direction—is in effect an income tax hike. Which (personally), I think is a bad thing.

Second, while (assuming constant tax rates) non-Roth and Roth produce the same result for the participant, switching to Roth-only doesn’t produce anything like the same result for the capital markets. A big chunk of money—10%? 20%?—that used to go straight into the capital markets when a participant made a contribution will now go straight to the federal government. And that is going to have some very negative effects on the economy. I hope the Congressional Budget Office (CBO) is modeling that.

And, finally, and getting to the cynical part—this whole proposal is just a budget gimmick. The CBO “scores” the tax effects of the 401(k) system using a 10-year window. Using that approach, non-Roth contributions front-load tax benefits (because the exclusion is taken in year one and the taxes are only paid at withdrawal, often in years outside the 10-year window). As a result of this scoring approach, the revenue “cost” of the non-Roth system is overstated. Roth contributions flip that treatment—front-loading the tax revenues, pushing the revenue cost (the non-taxation on distribution) outside the window, and thus understating the revenue cost.

Everyone knows this, and everyone knows it’s irrational. But instead of fixing this problem—say, by present-valuing the tax benefit—advocates of Roth-only are just trying to make the irrationality work for them. All in the service of producing more revenues so they can fund income and investment tax rate reductions and a corporate tax fix.

Bottom line 

All of which is to say: lawmakers should be reluctant to radically revise the current system—which, whatever its flaws, is producing meaningful retirement savings—in a way that could significantly compromise its effectiveness and drain assets from the capital markets, all in service of a budgeting artifice. Hopefully they will think twice before pulling the Roth-only trigger.

Michael Barry is president of the Plan Advisory Services Group, a consulting group that helps financial services­ corporations with the regulatory issues facing their plan sponsor clients. He has 40 years’ experience in the benefits field, in law and consulting firms, and blogs regularly http://moneyvstime.com/ about retirement plan and policy issues.