GOP tax reform: Time to ditch your 401(k) account?

Why the GOP Wants to Cut Your 401(k) Retirement Savings

GOP tax reform: Time to ditch your 401(k) account?

Republicans hoping to pass a tax reform bill this year are searching for ways to offset trillions of dollars in potential corporate and individual tax cuts. And one such way, which has been floated since at least April, is something called “Rothification.”

Under current law, some 132 million workers contribute to a 401(k) or similar plan on a pre-tax basis. These deferred wages, or what the IRS calls elective deferrals, are generally not subject to federal income tax withholding at the time of deferral. But distributions are taxed as ordinary income.

Now, truth be told, this tax deferral costs the government money in the short term. In fact, defined contribution plans will cost $583.6 billion in forgone tax revenue between 2016 and 2020 and traditional IRAs will cost $85.8 billion, according to the most recent numbers from the non-partisan Joint Committee on Taxation.

If, however, the government caps the amount workers can save on a pre-tax basis but lets them continue to save with after-tax dollars, it will recoup some of that foregone tax revenue.

Or at least that's the idea behind the House Republicans latest plan to limit the amount workers can save in their 401(k) to $2,400, from its current level of $18,000, or $24,000 for those age 50 and older.

To be fair, the most recent Rothification plan was dead on arrival. Among other things, the plan contradicted the stated goals of the Trump administration's and Republicans' Unified Framework for Fixing Our Broken Tax Code. That document states that tax “reform will aim to maintain or raise retirement plan participation of workers and the resources available for retirement.”

Rothification Is Misunderstood

So, why did Republicans float a dead-on-arrival idea? To make the tax cuts work over the budget-scoring window.

“As I understand it, the plan would limit the upfront tax deferment to $2,400, then anything above that amount would get Roth treatment,” said Andrew Biggs, a resident scholar at the American Enterprise Institute (AEI). Contributions to a Roth 401(k) or Roth IRA are made with after-tax dollars.

According to Biggs, the motivation for the plan to cap pretax savings has very little to do with retirement policy, which GOP lawmakers, he noted, unfortunately don't think very much about it.

“The idea is that by shifting to a Roth treatment of contributions, you'd get more revenues up front which would help pay for the tax cut over the budget-scoring window,” he said.

“You don't get more total revenues over the long term, meaning — that the policy doesn't really cut 401(k) subsidies, nor does it make the tax cut more affordable, because 401(k) balances would become tax-free on withdrawal.

Basically, it's just a way to front load tax revenues to make the short-term budget figures work out.”

In theory, the results need not be bad, said Biggs. “The overall tax treatment under Roth is basically the same as with regular contributions, you simply get the tax break later,” he said. “While some people do better under regular treatment, others do better under Roth. On average, it's pretty similar and the differences from person-to-person aren't huge.”

Moreover, Biggs said, research seems to find that when 401(k)s switch to Roth treatment, employees maintain more or less the same contribution rates.

“That means an increase in net contributions equal to the average marginal tax rate,” he said.

“So in theory, a Roth switch could increase retirement saving, especially to the degree that contribution rates in the future will be driven by auto-enrollment.”

Of course, not all agree with Biggs' assessment.

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Research earlier this year from the Investment Company Institute (ICI), the lobbying group for the mutual fund industry, found that Americans strongly value the current tax incentives for retirement saving and overwhelmingly oppose changing them.

In the study, American Views on Defined Contribution Plan Saving, 2016, ICI found that 89% of all U.S. households disagree with the statement that the government should take away the tax advantages of defined contribution (DC) accounts, and 90% disagree with the idea of reducing the amount that individuals can contribute to DC accounts.

Even among households that do not own DC accounts or individual retirement accounts (IRAs), 82% reject the idea of taking away the tax treatment of DC accounts.

Given that, Biggs said, people interpret the Roth switch as getting rid of the tax deferment. “A lot of public discussion and media headlines get this wrong,” he said. “To counter that, the proposal would allow regular tax treatment on contributions up to $2,400. That helps a bit with the optics, and in reality, very few people — and almost no low-earners — would be affected.”

Biggs noted, for instance, that 85% of people with incomes under $50,000 wouldn't hit that cap. “But if you think the current tax treatment is regressive, the cap makes some sense; it's high earners who'd be affected,” he said.

But together, Biggs said he's not sure how well it works.

“Those people who do save more than $2,400 may take that figure as a cap and reduce their saving, even if they could benefit from the Roth treatment,” he said.

“Moreover, if bosses or human resource managers who decide whether a firm sponsors a plan don't the cap, they may be less willing to have a 401(k) for their employees.”

Bad Optics or Bad Policy?

On paper, it's not a terrible policy, Biggs said. “But I think it gets screwed up by the budgeting and the politics,” he said.

“My big-picture political complaint for the GOP is that it often looks as if they care more about tax cuts for people at Mitt Romney-income levels than they do about ordinary people, say, middle class people saving for retirement. Even if that's not actually the case with this policy, it reinforces that view.”

Others, meanwhile, say Rothification is not just bad optics but bad policy, too.

In September, for instance, Sen. Sherrod Brown (D-Ohio), promised “one hell of a fight” if tax reform negotiators consider shifting retirement savings tax incentives to Roth accounts instead of 401(k) plans, as a way to pay for corporate tax cuts.

And in July, the American Benefits Council wrote to Senate Finance Committee Chairman Orrin Hatch (R-Utah), suggested that Rothification was inconsistent with its 10 principles for a national retirement savings policy.

“Americans' retirement savings should not be viewed by policymakers as a 'piggy bank' to pay for other tax priorities,” James Klein, the president of American Benefits Council, wrote at the time. “Rather than taxing contributions to retirement plans, we should be encouraging individuals to invest in their future, which is good for taxpayers and the nation's economy.”

Who Is Affected by Rothification?

So, what percentage of 401(k) contributors would ly be affected by the $2,400 threshold and what is the percentage of 401(k) employee contributions that would be above $2,400 and thus subject to mandatory Rothification?

According to the Employee Benefit Research Institute (EBRI), even at the lowest wage levels ($10,000 to $25,000), 38% of the 401(k) contributors would be affected by the $2,400 threshold. This number drops slightly for those with wages of $25,000 to $50,000 but then increases substantially. For those with more than $100,000 in wages, 87% would be affected.

EBRI also examined the percentage of 2015 contributions that would be impacted by the $2,400 threshold.

It found 58% of the contributions from 401(k) contributors at the lowest wage levels ($10,000 to $25,000) would be above $2,400 and thus subject to mandatory Rothification.

This number drops slightly for those with wages of $25,000 to $50,000 but then increases substantially. For those with more than $100,000 in wages, 80% would be affected.

EBRI also found 43% of the youngest 401(k) contributors, those ages 25 to 34, would be affected by the $2,400 threshold. This number increases for older participants. For instance, 64% of those ages 55-64 would be affected.

EBRI also found that the percentage of 2015 contributions that would be impacted by the $2,400 threshold. For the youngest 401(k) contributors (ages 25-34), 53% of the contributions would be above $2,400 and thus subject to mandatory Rothification. This number increases for older participants. For those ages 55-64, 75% of the contributions would be subject to mandatory Rothification.

The Downsides to “Rothification” of 401(k) Plans

Financial advisers who work with those saving for retirement say there are some notable downsides to the Rothification of 401(k) plans and such plans could adversely affect your retirement.

For one, few Americans understand Roth 401(k) accounts. For instance, two three retirement savers have either no understanding or a mistaken understanding of Roth 401(k) contributions, according to recent research from Cerulli Associates.

Despite that lack of knowledge, there is a growing set of workers who are keen on the idea of Roth 401(k)s, according to a recent report on the subject by Rob Austin, director of research at Alight Solutions. Read Tax now or tax later? The 'Rothification' of 401(k) plans.

Still, advisers including Jeff Carbone, a managing partner for Cornerstone Financial Partners, said one of the biggest issues or concerns he has with Rothification is that investors have grown comfortable with the tax benefits or deduction a 401(k) or a deductible IRA offers. “We change that without giving one a choice, the savings rate of Americans will decline,” he said.

“As we know, if one contributes to the 401 in the before-tax account, their income is decreased by that amount lowering the taxable income for the current year.

If we change the deduction and income is taxable in the year received, that may affect one's ability or inclination to save …

They may feel 'I would rather use the money today,' or, if it is taxable, they not be able to save as much in the plan,” Carbone said.

“We are a want-it-now society and have been taught, rightly so, that the tax benefits of the 401(k) are great,” he said. “Take that away and delayed gratification of tax-free income may not be enough especially for the millennial generation.”

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10 Key Facts About the Republican Tax Plan

GOP tax reform: Time to ditch your 401(k) account?

Republican leaders in Congress rolled out their long-anticipated tax bill, known as the Tax Cuts and Jobs Act, on Thursday. At long last, we have some key details about what a tax reform package might look . To put some numbers behind the rumors, here are 10 key facts we just learned about the tax bill as it stands now.

1. The corporate tax rate would drop to 20%

The Tax Cuts and Jobs Act includes a permanent corporate tax rate of 20%, down from the current rate of 35%.

During and after his campaign, President Trump repeatedly called for a 15% corporate tax rate, but Republican leaders have proposed a slightly less aggressive cut to 20%. Under the Tax Cuts and Jobs Act, corporations would be allowed to take immediate depreciation deductions for expenses over the next five years.

Image Source: Getty Images.

In addition to a reduced corporate tax rate, the bill calls for dramatically reduced repatriation tax rates. Right now, U.S.

corporations are currently holding trillions in foreign profits overseas in order to avoid the 35% tax they'd have to pay on those earnings to bring them back to the States. Apple alone has about a quarter-trillion dollars stashed abroad.

This new tax bill would allow corporations to repatriate internationally held cash assets at a 12% tax rate and non-cash assets at a 5% rate.

2. Four individual tax brackets

The tax framework released by Republicans in September called for three tax brackets with rates of 12%, 25%, and 35%, down from the current seven-bracket structure. The plan also mentioned the possibility of retaining a fourth, higher bracket to ensure that the tax system stayed sufficiently progressive (i.e., kinder to lower-income taxpayers than to wealthy taxpayers).

The Tax Cuts and Jobs Act does indeed include a fourth tax bracket with the same 39.6% rate as our current highest tax bracket. Here are the taxable income thresholds above which each marginal tax bracket would go into effect.

Marginal Tax Rate

Married Couples














Data Source: The Tax Cuts and Jobs Act.

3. Standard deductions are up, personal exemptions are out

The GOP tax framework called for a near-doubling of the standard deduction to $24,000 per married couple and $12,000 for individual taxpayers. However, the personal exemption would be eliminated, which could result in a lower overall deduction and possible tax increase for families, especially those with several children.

4. Child tax benefits would improve

For families, greater tax breaks for parents may offset the loss of personal exemptions. The Tax Cuts and Jobs Act calls for raising the Child Tax Credit from $1,000 to $1,600 and also adds a $300 credit for Americans with non-child dependents.

5. The estate tax will be phased out

The Tax Cuts and Jobs Act calls for doubling the exemption amount for the estate tax from $5.6 million (the 2018 threshold) to $11.2 million and will eliminate it completely after six years. Republicans have been trying to get rid of what they call the “death tax” for a long time. Now it appears they may finally get their way.

6. The Alternative Minimum Tax will be repealed

The Tax Cuts and Jobs Act calls for a repeal of the alternative minimum tax (AMT), a parallel income tax system designed to make sure wealthier Americans pay their fair share in taxes.

Because taxpayers with many income streams tend to qualify for many tax deductions, some wealthy Americans could reduce their tax burden to little or nothing — if not for the AMT.

The AMT allows far fewer exemptions and deductions than the standard income tax system, and taxpayers whose income exceeds a certain threshold are required to calculate their taxes using both methods and pay the higher of the two resulting amounts.

Republicans have been trying to eliminate the alternative minimum tax, at least in its current form, for years. Not only is it seen as a complication in an already-complicated tax system, but it has increasingly begun to affect middle-class taxpayers, which it was not intended to do.

7. 401(k) and other retirement account tax breaks remain

President Trump recently assured the American public that no changes would be made to their 401(k)s in the tax bill, although there have been some reports that the maximum annual 401(k) deduction could be dramatically reduced.

Fortunately for retirement savers, the Tax Cuts and Jobs Act retains the current 401(k) deduction and contribution limits, as well as the limits for other deductible forms of retirement savings IRAs.

8. The state and local tax deduction will go away

The Tax Cuts and Jobs Act would eliminate the state and local tax deduction. This has been perhaps the most contentious part of the GOP's tax reform plan so far.

After all, tens of millions of Americans claim the SALT deduction each year, deducting state and local taxes on sales, income, property, and more.

Though eliminating this popular deduction would help pay for the tremendous tax cuts elsewhere in the Tax Cuts and Jobs Act, it could cost Republicans valuable support in high-tax states New York and New Jersey.

9. Mortgage interest, charitable contributions, and property taxes remain deductible

These three expenses will remain deductible under the Tax Cuts and Jobs Act, though the higher standard deduction would make them less useful to millions of Americans.

The deductions for mortgage interest and charitable contributions were never on the chopping block, but the ability to deduct property taxes up to $10,000 is ly a compromise to appeal to lawmakers in high-tax states.

And it's worth noting that for newly purchased homes, the mortgage interest deduction will be limited to homeowners with mortgage balances of $500,000 or less.

10. Small businesses, “pass-through” income

The Tax Cuts and Jobs Act cuts the maximum rate on small businesses to 25%. While there would be several rules in place designed to prevent abuse of this rule — after all, there is some ambiguity to what exactly qualifies as small business income — this could be a big tax break for small business owners.

“,”author”:”Matthew Frankel, CFP (TMFMathGuy)”,”date_published”:”2017-11-02T16:43:00.000Z”,”lead_image_url”:””,”dek”:null,”next_page_url”:null,”url”:””,”domain”:””,”excerpt”:”The Tax Cuts and Jobs Act would make some major changes to the U.S. tax code.”,”word_count”:1023,”direction”:”ltr”,”total_pages”:1,”rendered_pages”:1}


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