Why the ‘Rothification’ of 401(k)s Would Hurt Retirees

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Wharton’s Olivia S. Mitchell speaks with Wharton Business Daily on Sirius XM about the downsides to the ‘Rothification’ of 401(k) plans.

The ability to defer taxes on 401(k) contributions is a big incentive for individuals funding retirement accounts. However, a proposal making the rounds on Capitol Hill seeks to tax those contributions instead of taxing payouts. The argument is that doing so would bring the government more tax revenues in the short run.

Such a move would have seriously negative implications on how much people accumulate in their retirement accounts over their working lives, and also for overall government tax collections, according to experts at Wharton and the Goethe University of Frankfurt.

Under current rules governing employer-based defined-contribution retirement plans, U.S. workers build their 401(k) savings with pre-tax deductions from their paychecks. That causes the federal government to “forgo” about $100 billion annually in current taxes. “Some of that does come back later, when people retire and pay taxes on their benefits,” according to Wharton professor of business economics and public policy Olivia S. Mitchell, who is also director of the Pension Research Council at the school. She spoke on the Wharton Business Daily radio show on Sirius XM. (Listen to the podcast at the top of this page.)

“The model that’s being proposed is to flip the tax structure, so that instead of putting in tax-free money or tax-deferred money, you would pay tax on your income, then decide how much to contribute and get it tax-free later,” Mitchell said.

That model is similar to Roth IRAs (individual retirement accounts), where people make their contributions with after-tax dollars. They are named after the late Senator William Roth, who introduced the legislation allowing that tax treatment in 1997.

In a Roth world, “the advantage to the government is that they would hurry up the access to the tax money,” Mitchell noted. “[But] such a ‘Rothification’ of retirement savings would alter household saving, investment, and Social Security claiming patterns, besides compelling people to work longer years and spend less on consumption.” Those findings are the result of a recently published study that Mitchell co-authored with Raimond Maurer, dean of the faculty of economics and business administration at Goethe University of Frankfurt and Vanya Horneff, a post-doc in finance at that university.

As of September 2019, Americans had $5.9 trillion in their 401(k) accounts, according to data from the Investment Company Institute, an association of regulated funds based in Washington, D.C. Investors have the choice of investing in either a Roth IRA or a 401(k) plan, or both, with varying tax benefits.

“A ‘Rothification’ of retirement savings would alter household saving, investment, and Social Security claiming patterns….” –Olivia S. Mitchell

The idea to tinker with the tax treatment for 401(k) contributions is not new. President Barack Obama recommended a pre-tax pension contribution cap in 2015, and related proposals were offered by the Trump Administration during the 2017 tax reform debate, Mitchell and her coauthors noted in their paper. The 2017 Tax Cuts and Jobs Act, which lowered taxes effective 2018, also changed the relative attractiveness of saving for retirement in 401(k) accounts, since lower marginal tax rates on workers’ earnings decreased the attractiveness of saving in 401(k) accounts, the researchers added.

Mitchell said the latest round of discussions on “Rothification” of retirement accounts started at the national level a couple of years ago when the Trump administration started talking about tax reforms. “Right now, the federal deficit is more than a trillion dollars, the federal debt is $23 trillion and the Social Security shortfall is $43 trillion,” she noted. “Sooner or later, we’re going to have to start looking at sources of new revenue.”

Long-term Impacts in a Roth World

In a Roth world, workers over their lifetimes would accumulate about a third less in their 401(k) accounts, the study found. That is because the absence of a tax advantage in making those contributions would lead them to save less, and those lower contributions would earn less over the years than under the current regime that allows pre-tax contributions.

For example, the average worker in the age group of 60 to 69 would accumulate 401(k) assets of $127,100 in the current regime that allows pre-tax contributions, versus $91,100 in the after-tax “Roth” scenario, assuming a 1% interest rate. If the interest rate is 3%, the corresponding 401(k) savings would be $162,900 for pre-tax contributions and $105,300 for after-tax contributions.

Those reduced savings by individuals would hurt the government’s tax coffers as well. They would lower the lifetime tax revenue generated by the average worker by between 6% and 10% compared with the current regime, the study found. Over the complete life cycle, tax payments average 6% more ($24,000) in the prevailing 401(k) regime with pre-tax contributions and when the interest rate is low. That difference increases to about 10% ($42,000) if the real rate is 3%, according to the study.

Even as a “Rothification” of retirement savings accounts would lower tax collections in the long run, it wouldn’t hurt the present government. That is because the government and Congress have a 10-year window for calculating the benefits and costs of different tax changes, said Mitchell. “It would look good, because all these extra revenues would pop up during the 10-year window, and the losses or the lack of collection of taxes later would not be calculated.”

“Switching to a system where contributions to retirement accounts are made only with after-tax money would boost tax revenue in the near term, but not as much as it would reduce it in the longer term. And it would leave retirees worse off,” Mitchell and Maurer wrote in a recent opinion piece in The Wall Street Journal.

A Nuanced Model

The study’s authors built a dynamic life cycle model to show how and whether taxing 401(k) contributions rather than payouts would alter household saving, investment, and Social Security claiming patterns. Mitchell described that as “a very realistic model [that takes] into account all kinds of details that haven’t been focused on before.”

“Sooner or later, we’re going to have to start looking at sources of new revenue.” –Olivia S. Mitchell

Mitchell pointed out why such calculations get complicated: For one, people are not necessary in the same tax bracket when they are working as when they retire because of the progressive income tax regime. Social security benefits are taxable, also in a progressive scale, and they are only partially subject to tax. Also, those who withdraw their money too early from a retirement account have to pay a penalty, plus income tax. “Our model takes all these complex stories into account, and then we try to predict what the effect of ‘Rothification’ would be,” she said.

The study also computed how consumption paths would differ, and raised the question of whether retirees would be able to consume more or less in a Roth world. “We estimated that consumption for retirees would be substantially less,” said Mitchell “So all in all, people would work a little bit longer. That may be good for the Social Security system, but they’re giving up leisure. They’re going to consume a little bit less, so it would not help retirees.”

The proposed new tax system would impose different tax burdens on low-paid workers and higher-wage workers, Mitchell and Maurer wrote in their Journal op-ed. “During their working lives, the lack of a tax deferment for retirement savings would result in a bigger tax hit for workers in higher tax brackets than for those who make less. But in retirement, higher-paid workers would benefit more on the tax front, since they tend to make larger withdrawals from retirement accounts.”

Another key point the study found is that low-wage workers — people with a high school education or less — would actually not be that affected by a switch to the Roth system. “[That is] because (a) they’re not saving that much, anyway; (b) they’re not paying that much income tax,” said Mitchell. “So the group that would be most influenced by the change to having the money go in after tax, and then being able to take it out without paying tax later is the college-educated population. And they would be the ones who would be working longer and potentially consuming a little bit less.”

Significantly, the study also considers the mindset of individuals when it comes to putting money away for retirement. If it gets automatically deducted from their paychecks, they tend to save more than if they have to plan for it after they get their paycheck and after their taxes are deducted. “One of the great advantages of having a retirement account at your place of employment is that if the money is out of sight, it’s out of mind,” Mitchell noted.

Further, the study analyzed how its findings would differ if the economy were to move out of the very low interest rate environment of the last decade, and return to a more “normal” regime. “Persistent low returns spur workers to save and invest differently and can also drive different decisions about how long to work and when to claim Social Security benefits,” the authors wrote. The quantitative easing policies of the U.S. Federal Reserve after the 2008 financial crisis have resulted in “extraordinarily low” real U.S. Treasury yields over the past decade, compared to the normal historical real return of 3% witnessed in the 1989-2008 period, they added.

In the prevailing regime of pre-tax retirement savings when interest rates are low, “the net-of-tax gain from delaying Social Security claiming is relatively small, [but] the effect is stronger when interest rates are high, because workers build more assets in their 401(k) accounts,” the paper stated.

Those complex tax considerations become irrelevant in a Roth world, because pension withdrawals are not counted as part of taxable income, the paper noted. But that was also not entirely clear cut. “We modeled low-income, middle-income, and high-income workers so we could get a sense of the distributional impacts, as well,” said Michell. “What we did find is that in the Roth world, where you pay taxes on your income first, and then you don’t pay income taxes later, is that people would actually work slightly less — fewer hours per week — but they would delay claiming, in order to get higher Social Security benefits.”

“If you don’t know whether you’ll be able to keep your money protected from tax downstream … then it’s very difficult to decide where to invest, how to invest, or whether to invest.” –Olivia S. Mitchell

Uncertain Times Ahead

How a Roth world would impact Social Security withdrawals is significant because of the poor state of finances on that front. Social Security benefits will start to exceed the program’s costs in 2020, and the program will deplete its $2.9 trillion reserve fund in 2035, a Barron’s report noted, citing last year’s annual report from the Social Security Trust Fund.

Mitchell stressed that now is the time to weigh the long-term implications of the proposed tax changes to retirement accounts. “It’s critical to start looking at how we’re going to solve some of these big debt and deficit issues, because the uncertainty that these factors have, that they impart to business managers, [and] to people thinking about investing, is enormous,” she said. “If you don’t know whether you’ll be able to keep your money protected from tax downstream, or at least have the current tax rules be predictable, then it’s very difficult to decide where to invest, how to invest, or whether to invest.”

The Roth model is attractive to retirees in that they don’t have to worry about paying taxes on their withdrawals, especially in times when they may have to worry about their spending on health expenses and so forth. Mitchell agreed that “this is a real appeal of the Roth model … as long as the rules are kept inviolate, [and] they’re maintained. The promise that you won’t have to pay taxes on your retirement benefits can [help] you plan and anticipate a more secure retirement.”

However, she was not sure if all that is set in stone. “Given the big financial problems that the government faces, who knows if those promises will be kept?”

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