Barry’s Pickings: A Big Win for Retirement Savings Policy

The most significant thing, for retirement savings policy, about the tax bill that President Donald Trump just signed into law is what didn’t happen. Congress did not “Rothify” 401(k) savings to fund the corporate tax cut.

Rothification would have required that some or all of 401(k) contributions go in after being taxed. Tax-free accumulation plus a tax-free distribution, it was argued, make Roth contributions equivalent to “regular” 401(k) contributions, which go in pre-tax, accumulate tax-free and then are taxed on the way out.

That argument ignored the very substantial tax benefit that many participants enjoy from shifting their income from a current high-tax year, e.g., in mid-career, when they are at peak earning power, to a future low-tax year, e.g., in retirement.  Roth contributions only allow tax-advantaged income shifting the other way, from a current low-tax year (when, under Roth treatment, taxes are paid) to a future high-tax year (when, under Roth treatment, taxes aren’t paid).

There was widespread outrage over word that Congressional Republicans were considering Rothification, perhaps only allowing “regular” 401(k) treatment of the first $2,400 of 401(k) contributions. In response, President Trump tweeted “There will be NO change to your 401(k). This has always been a great and popular middle class tax break that works, and it stays!”

Along with President Trump, it was—interestingly—Democrats who led the charge in attacking this proposal, with Senate Minority Leader Chuck Schumer, D-New York, describing it as a “tax hike on middle-class retirement accounts.” Only a few years ago Democrats were decrying the 401(k) system as providing “upside down” incentives. Hopefully, after this experience, they will stay on our side.

I think this income shifting feature may provide a clue to 401(k) plans’ broad appeal to the “middle-class” and not just the highly paid. The value of income shifting doesn’t depend on the level of taxation, it depends on the difference between brackets. So it works just as well (and in some cases even better) for the middle-class as for the highly paid.

Consider the relative value, under the new law, of a highly paid taxpayer shifting income from a year in which he makes $300,000 (and is paying tax at a 24% rate) to a year (for instance, post-retirement) in which he makes $125,000 (and is paying tax at a 22% rate) versus a “middle-income” taxpayer shifting income from a year in which she makes $100,000 (and is paying tax at a 22% rate) to a year in which she is making $70,000 (and is paying tax at a 12% rate). The highly paid taxpayer is reducing his tax rate by only 2 percentage points. The middle-income taxpayer is reducing hers by 10 percentage points. On these assumptions, being able to save (non-Roth) in a 401(k) produces a much bigger relative tax benefit for the middle-income taxpayer.

This feature of 401(k) plans is under-studied and barely discussed. But I think—and the outcry over Rothification makes this obvious—participants, while they may not understand the theory, intuit its power.

My takeaway from this controversy—the 401(k) system is a lot more popular and has more political leverage than many of us thought.

Another big win for retirement savings is the reduction in the corporate tax rate. There was a time this summer when Senator Orrin Hatch, R-Utah, was considering a corporate tax system (corporate “integration”) in which corporate dividends would generally be fully deductible but subject to mandatory nonrefundable withholding. Under such a system, tax-exempt trusts—e.g., retirement plan trusts—would pay the tax that the corporation was no longer paying. Nothing like that happened in the final tax reform bill.

Instead, retirement plans (and other tax-exempt entities), which indirectly pay the corporate level income tax, got a massive tax cut. This translated into a run-up in stock prices and is likely to result in further capital appreciation and increased investment returns for retirement savers. Those gains increase the value of qualified plan tax treatment, because, in a tax-qualified plan, those gains are untaxed.

Again, participants (and, indeed, some experts) may not understand the theory here, but for 2017 they are looking at around a 20% return on their stockholdings, all of it untaxed. They are very happy with their 401(k)s. Indeed, it’s possible that if, e.g., U.S. equities lost 20% this year participants would not have been nearly as concerned about Rothification.

All of this is cause for much optimism about the current system.

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.