Do the tax incentives of traditional 401(k) plans really provide incentive to save for retirement?
That question may emerge at the forefront of Congress’ debate over tax reform, which is expected to ratchet up when lawmakers return from their summer recess in September. The White House has pledged to have a tax reform bill on the Senate floor by November.
Details on the framework for reform are few at this point, but at a recent forum hosted by Americans for Prosperity, a conservative activist organization, a White House official confirmed that the tax-preferred status of 401(k) and IRA contributions are being considered to offset lower individual tax rates.
Proponents of preserving the traditional system argue that eliminating or reducing deductions on contributions to 401(k) plans will result in lower savings rates at a time when the country is facing a retirement savings crisis.
A survey of employers from the Plan Sponsor Council of America found that nearly nine in 10 sponsors said reducing or eliminating the tax incentives to contribute to 401(k) plans would reduce savings rates.
But recently published research from the Harvard Business School counters that presumption, showing contribution rates to Roth 401(k) plans were equal to those made to traditional plans. Roth contributions are taxed as regular income, but withdrawals in retirement are tax-free.
And recent data from 401(k) service provider Alight Solutions, the former record-keeping arm of Aon Hewitt, shows participants actually increased contribution rates when they shift deferrals to Roth plans.
According to Alight’s plan universe benchmark report, which draws data from 3 million participants, 25,000 individuals shifted to a Roth plan between 2015 and 2016.
Roth users’ average savings rate was 9.7 percent of salary, a full 2 percent higher than the average contribution rate to traditional 401(k)s.
Rob Austin, director of research at Alight, says that while notable, the firm’s data doesn’t necessarily conclude that all participants would save more under a Roth design, or that reducing or eliminating the tax incentives in traditional plans would not lead to lower savings rates.
“The question comes down to what participants would do if a Roth system were required,” Austin told BenefitsPRO. “Nobody can say with any certainty.”
Austin says Alight’s data on increased deferrals to Roth plans could be explained by several factors.
One is a higher level of financial savvy. The choice to weigh the tax treatment of deferrals based on assumed tax rates in retirement compared to taxes during working years suggests a level of financial literacy on the higher end of the participant spectrum, says Austin.
Also, the participants that switched to the Roth format took the initiative to do so. “They actually went into their account, saw what their saving rate was, and maybe realized they needed to start saving more,” said Austin.
“The increase in savings rates was sizeable,” noted Austin. “But it is important to consider that people willingly did this on their own.”
Employer-sponsored defined contribution plans held more than $7 trillion at the end to of 2016, according to the Investment Company Institute. Most was in 401(k)s--$5 trillion as of March 2017.
Rollovers from employer-sponsored plans account for about half of the $8.2 trillion IRA market.
Data from the PSCA shows that Roth 401(k) offerings are becoming standard fare in plan design. In 2014, 62 percent of plans included a Roth offering, with 70 percent of plans with fewer than 50 participants offering the after-tax savings option.
Deferral rates to traditional 401(k)s were higher than to Roth plans in 2014, according to the PSCA.
But Harvard’s study found no difference in contribution rates when it looked at 11 companies’ participants’ data between 2006 and 2011.
While the Harvard study does not recommend policy changes to the tax treatment of 401(k) deferrals, it does draw a conclusion that could influence lawmakers: Unchanged contribution rates to Roth 401(k)s translates to more savings for retirement, based on the fact that the Roth withdrawals are not taxed.
Seven of the companies reviewed by the Harvard study were financial services firms with average salaries of $100,000. That suggests a level of high financial literacy among higher earners that may have impacted the study’s results.
The basic guidelines that often influence savings habits in traditional 401(k)s—contribute the maximum amount, at least enough to earn employer match, or 10 percent of income—also apply when factoring savings to Roth plans, the Harvard study said. That in part explains the balance between traditional and Roth contribution rates.
Jack VanDerhei, research director at the Employee Benefit Research Institute, thinks the findings in the Harvard study have some limitations.
“They were only able to study the impact of Roth on a voluntary basis, and the Roth option is likely limited to individuals who have sufficient resources to continue the same 401(k) contribution rate and lose the tax exemption,” VanDerhei said in an email.
“Those individuals most likely to be subject to a budget constraint under a Roth system may not be in the data,” added VanDerhei. EBRI is scheduled to release new data assessing how Roth savings impact lower wage earners.
Can tax reform happen without some Rothification?
The most aggressive option lawmakers are reportedly considering would replace the traditional, pre-tax 401(k) system with an all-Roth after-tax platform.
Ed Murphy, president of service provider Empower Retirement, recently told BenefitsPRO that is “highly unlikely” to happen.
Another idea for reform comes from former Congressman Dave Camp, R-MI, when in 2014 he advanced the idea of limiting pre-tax 401(k) contributions to half of the statutory limit. The other half could be invested in Roth accounts.
Camp also wanted to replace the traditional IRA with an all-Roth system in the retail market.
Alight’s Austin describes the firm’s position on tax reform as agnostic. About 75 percent of the firm’s sponsor clients already have a Roth feature in place. Austin said any shift to a Roth system would not materially impact Alight’s revenues.
The larger question is whether it would impact 401(k) participants’ retirement security, says Austin.
“We think the employer system is really strong,” said Austin. “And nobody would win if a policy change would result in people saving less.”
But the reality is that any attempt to reduce marginal individual rates will have to be paid for, and retirement plans have a big target on their back.
The Joint Committee on Taxation, an independent arm of Congress that advises both chambers on the tax code, says the tax breaks on 401(k) and IRA contributions will cost the Treasury Department $670 billion in foregone revenue between 2016 and 2020.
The JCT and the Congressional Budget Office will score any proposed tax reform on a ten-year basis. The White House has said it will protect the mortgage interest deduction and charitable deductions in the code.
Those are complete expenditures, noted Austin, whereas traditional 401(k) contributions are deferred expenditures. Revenue is forgone in the near term, but ultimately recovered when withdrawals are taxed in retirement.
That 401(k)s are being considered as complete expenditures irks a lot of people, said Austin.
“As policy makers weigh the options, they shouldn’t think of changes to 401(k)s in isolation of the near-term revenue gains,” he said.
Austin describes the need to balance revenue-neutral tax cuts with savings incentives as a delicate dance.
“I think an all-Roth system is politically unlikely,” said Austin. “But ultimately, it could be the path if the numbers work.”