As Congress considers modifying the tax-preferred treatment of defined contribution plans within tax reform legislation, lawmakers so far have proven willing to listen to input from retirement industry stakeholders, according to Ed Murphy, president of Empower Retirement, the country’s second largest service provider to 401(k) plans.
Over the past several months, Murphy has been actively engaging with House leaders and the members in both parties that will drive tax legislation.
“Anything and everything is on the table with tax reform,” Murphy told BenefitsPRO.
Conceivably, that includes a proposal to treat all contributions to retirement plans on an after-tax basis, as Roth 401(k) and Roth IRAs are now taxed, perhaps the most dramatic option under consideration for the $4.8 trillion 401(k) market.
While cautioning that it is still early in the process, Murphy thinks it is “highly unlikely” that Congress will embrace an option to move an entire retirement savings system to the Roth model.
The most recent numbers from the non-partisan Joint Committee on Taxation show defined contribution plans will cost $583.6 billion in forgone tax revenue between 2016 and 2020. Traditional IRAs will cost $85.8 billion.
Those numbers represent one of the largest sources of forgone revenue from deductions in the tax code, and are undoubtedly an attractive source for offsetting trillions of dollars in potential corporate and individual tax cuts.
But the consensus among retirement policy experts and non-partisan economists is that the tax incentives for saving in qualified retirement plans are critical for buoying savings rates, and that any potential shift to an after-tax contribution system carries the considerable risk that savings rates will drop at a time when much of the workforce is facing savings shortfalls.
Murphy expects lawmakers from both parties to be sympathetic to that risk as they consider options for tax reform.
“Nearly everyone acknowledges we have a retirement savings crisis,” said Murphy. “If you brought forward a proposal that carries short-term revenue benefits, but might have a catastrophic long-term impact on retirement security, I think you would have members on both sides of Congress saying we need to take the longer-term view. Any option that would discourage people from saving would be not good for the country’s long-term growth prospects, or good for society overall.”
Camp proposal will struggle for traction
Another proposal reportedly being considered on the Hill emerged from former Congressman Dave Camp, R-MI, when he chaired the House Ways and Means Committee in 2014.
If nothing else, it proved the vulnerability of the existing 401(k) system for a tax plan that was in some respects less aggressive than the current Republican Blueprint for reform—Camp wanted to reduce the corporate rate to 25 percent, while the Blueprint calls for a 20 percent rate.
Camp’s idea was to limit pre-tax 401(k) contributions to half of deferral limits, and eliminate the traditional IRA in favor of the Roth IRA.
Murphy is not confident Camp’s plan has legs, but that it is more likely to be part of a compromised solution. “It’s not inconceivable that they arrive at a hybrid solution, with some cap on pre-tax dollars and potentially higher deferral limits. We are not saying that there are not changes that can be made,” said Murphy.
Beyond the potential impact on savings rates, lawmakers will have to weigh the interests of employers, who face payroll and health care cost risk, among other areas of exposure, when their workforce is unable to retire because of inadequate savings.
“My sense is that most plan sponsors would have real concerns over proposals that would take away incentives to save, irrespective of what tax benefits they may get,” said Murphy.
New data is needed, and is coming
Precise data linking Roth plans and savings habits has yet to be mined, in part because Roth 401(k) assets are dwarfed by assets in traditional plans. In Morningstar’s database of 430,000 plan participants, Roth plans only account for 2.5 percent of assets. In the Vanguard universe, participation in Roth plans is only 5 percent.
In 2012, the Thrift Savings Plan, the defined contribution plan for federal government employees, added a Roth contribution option. Average after-tax deferrals were 4.4 percent of income in 2013, compared to 7.7 percent for traditional, pre-tax deferrals.
Deferral rates into Roth plans were lower in every age group and income quintile in the TSP. The highest earners deferred about half as much salary to Roth plans as to traditional plans. Workers 70 and older contributed about 6 percent of salary to Roth plans, compared to 10.6 percent of salary in traditional plans. For the 50 and under cohort, Roth contribution rates were low, at 3.5 percent.
But those are just raw data points from one plan—albeit a large one. Moreover, the Roth contributions were made voluntarily with a pre-tax option available, and are not conclusive on what a fully or partially “Roth-ifed” system would do to savings rates.
At this point in the process, economists and stakeholders are cautioning Congress against advancing proposals without new analysis on how a Roth-structured system will impact savings habits.
The Employee Benefits Research Institute is weeks away from releasing a new study that examines Roth plans’ impact on savings habits. And the Bipartisan Policy Center is working to release new budget model on how a Roth transition will impact federal revenues.
While the data is not fully in, Jack VanDerhei, EBRI’s research director, says the logical assumption is lower wage earners would be most affected. “They have the most budget constraints on take-home pay. If their contributions come after tax, I think they would be the ones most likely to cut back deferrals.”
How employers would act under a new system would also be consequential to future savings rates, said VanDerhei. “What employers do would account for a huge impact. Do they modify automatic enrollment, and give employees the option to opt out of set savings rates under a Roth system? I think it’s safe to say you would see the biggest deferral reductions with participants that are voluntarily enrolled.”
Shai Akabas, the director of fiscal policy at the BPC, is concerned that sound retirement policy could be forsaken for tax reform purposes. “We should be looking at retirement policy on its own merits.”
Beyond what Akabas says are very real questions about the long-term fiscal value of removing or limiting existing tax incentives, the biggest question is how these policies would impact participant behavior. “My inclination is that it will reduce savings rates,” he said.
From a budgeting perspective, the concern BPC is attempting to address with its new research is whether the short-term savings gained from limiting 401(k) tax deductions will ultimately amount to long-term losses.
“The general contours are clear—shifting to an all-Roth system would move a lot of money we know would be coming in down the road into the current 10-year budget window. We know that would have a substantial revenue impact, but the fiscal impact is unclear. If you claim savings and spend them somewhere else, that will create a negative impact on the long-term fiscal picture,” said Akabas.
Ultimately, the task of scoring proposals to change the existing system, and predicting their impact on plan participants’ behavior, is extremely complex, and ultimately an imperfect process, says Akabas.
“There are so many different pieces to the puzzle that conclusively determining the impact of these policies is probably impossible,” he said. “That’s the challenge we’re facing with this issue. I would be highly skeptical of any report that claimed to be exactly conclusive.”