If they lower the pre-tax deferral limit, we will lose several decades of progress on retirement security for Americans.
This concept, being referred to as “Rothification” is viewed as a tax revenue raiser in Washington thanks to their use of a 10-year budget window. The reality is that 401(k) pre-tax contributions result in DEFERRED TAXES, and not lost tax revenue. But when you only look at the puts and takes of the next 10 years, you only see a bunch of money coming in if they were to limit the 401(k) pre-tax limit to a lower amount and allow the remaining amount up to $18,500 to be Roth.
This will definitely hurt many/most workers who participate in 401(k) plans in one or more of the following ways:
First, for the working class/middle class/upper middle class (let’s pick a number of say $150k/year), they stand a good chance of losing out on the main tax benefit of 401(k) pre-tax deferrals – saving tax at their marginal tax rate in their working years, and paying tax when they withdraw the money in their retirement at their effective tax rate in retirement. Most of those people will not be the the same tax brackets in retirement. Those that make substantially more than $150k will likely not be in a materially lower tax bracket in retirement, so they don’t really benefit today from the tax arbitrage opportunity. Also, the states often follow the Federal rules so many states don’t tax 401(k) pre-tax contributions and if the residents move to low/no state income tax state in retirement, those 401(k) pre-tax contributions would never incur state taxation, whereas Roth contributions are taxed.
Second, there has been some good progress made in the past 10 or so years automatically enrolling (and in many cases automatically escalating contribution rates) for employees at many companies. Inertia plays a role in this as the employees don’t have to do anything – there are some that think that same employee inertia won’t result in people reducing their contributions, but I disagree. Employees are going to get a cut in take home pay, which will clearly show up on their paychecks as additional tax withholding. So by the same Washington logic of just looking at the current tax situation, every contributing worker is going to see their tax withholding go up and their net paycheck go down if this becomes law. Some/many will reduce their contribution rates as a result of this and beyond saving less of their own money, they may also lose out on some portion of their company matching contributions as a result.
Third, I can see many employer plans offering an option to contribute X% of pay not to exceed the pre-tax contribution limit (e.g., $2,400) and then Y% of pay as Roth. Employees who choose that option will likely save less and also may receive lower company matching contributions as a result of this if they don’t contribute enough to maximize the match.
Fourth, let’s go back to that 10-year budget window that Washington uses. What’s going to happen in 10-20 years from now when more retired people are drawing down Roth funds and not paying taxes? With lower tax revenue, Washington will need to raise taxes some other way. Guess what will look like a nice fat piggy bank to them at that time – yep, those Roth 401(k) plans. Someone will inevitably point out that there were investment returns that were not taxed, and I can just see what that will lead to. If you don’t think it will happen, look at Social Security – it was originally tax free, then it was taxed up to 50% (in theory the employer portion), and now I believe up to 85% is taxable for some higher earners (the 15% representing an estimate of the post-tax payroll taxes).
If Rothification is necessary to get tax reform to work, then the limit should be set at one-half of the current limit. In other words, using the 2017 figures as a proxy (since the numbers are rounder), let the first $9,000 be traditional pre-tax 401(k) and the other $9,000 to get up to the $18K limit be restricted to Roth. That way someone making $150K can contribute 6% pre-tax and still be under the limit (my upper-middle class example). Those putting in more than $9K can do the excess as Roth, and most aren’t likely to be in a materially higher tax bracket in their working years than they will be in retirement.
They can even present $9k it as a tax increase on the more well to do (looking solely at the 10-year budget window), and in fact it may not increase the overall, long term taxes at all on many of those that would be affected at the $9K level. For example, whether I put in $9k pre-tax or $6K Roth, assuming a 33% combined Federal & State effective tax bracket in all years makes me completely indifferent.
Actually, Roth can be very beneficial for a higher tax bracket earner who already maxes out their 401(k) and saves elsewhere on an after tax basis – by using Roth they can potentially shelter more investment income from ever being taxed. The math gets a little fuzzy but if someone was going to max out their 401(k) and then save more elsewhere, they might be better off doing Roth. For this example, assume someone is in the combined 33% tax bracket and can afford to save $27K of gross pay.
- If they were to save $18K pre-tax and another $6K in a non-401(k) account ($9K gross, less 33% witholding leaves $6k).
- Alternatively, they could save $18K Roth ($27K less $9K in withholding).
Let’s just assume a 20-year time horizon and those investments triple in that timeframe (which equates to slightly less than a 6% compound return), and again assuming the same tax rates of 33%, the combined pre-tax/post-tax account would be worth $72K, $66K of which is taxable at 33% resulting in a $22K tax liability. That leaves $50K of tax free retirement income. The Roth account is now worth $54K, and unless Washington reneges on the Roth promise, there is no tax liability.
Sorry for ranting – this is personally a sore point for me as someone who has saved 10% or more (including company match) in 401(k) plans for more than 25 years. I realize most don’t have that luxury of being able to afford to save that much and/or don’t have a company match, but we already have a retirement crisis in this country and this is NOT going to make it any better.
