Do Roth 401(k)s and traditional 401(k)s yield the sameretirement income for savers?

The question of the advantages—and disadvantages—of Roth 401(k)shas taken on greater urgency as lawmakers contemplate capping oreliminating contributions to traditional 401(k)s, the deferrals towhich are made on a pre-tax basis.

Much of the conventional wisdom in the retirement industry hasassumed that 401(k) savings plans, whether designed on thetraditional pre-tax basis, or the Roth after-tax basis, yieldsimilar levels of retirement income.

But new analysis from Morningstar shows that for somemiddle-class wage earners, a Roth savings strategy can yield lessretirement income.

“Roth accounts are not bad for everyone,” Aron Szapiro, directorof policy research at Morningstar, recently told BenefitsPRO. “Butit is not accurate to say that there is no difference in theretirement income the accounts generate.”

A recent study published in the Harvard Business Review foundthat savers in Roth accounts did not lower their contributionrates.

Under that scenario, Roth savers could benefit from higherincome in retirement, as their withdrawals are not taxed.

Other recent analysis from Daniel Hemel, a professor of tax andadministrative law at the University of Chicago, compared theexperiences of a Traditional and Roth saver over 20 years.

Hemel measured the experience of hypothetical investors withmarginal tax rates that remained the same in retirement and foundthat the retirement income generated was equal, regardless ofwhether savings were made on a pre-tax or after-tax basis.

But Morningstar’s Szapiro says those and other approaches toestimating the retirement income that Roth and Traditional accountsgenerate fail to calculate a subtle, but important, distinction inthe tax code: the difference between the marginal tax rate andeffective tax rate.

When savers contribute to a traditional 401(k), they avoidpaying the marginal, or highest rate of a given tax bracket in theprogressive code, on those savings.

When savers contribute to Roth accounts, the contributions aretaxed, but in many cases at a savers’ effective tax rate, which isalmost always lower than the marginal rate.

In a recent paper, Szaprio looked at a 30-year-old saver making$50,000 a year, which would put her marginal tax rate at 25percent.

The saver contributes 10 percent of income to a Traditional401(k), but reduces the contribution to 7.5 percent in her Rothaccount so as not to lower her take-home pay.

When applying level rates of investment return and drawdownstrategies in retirement, and accounting for Social Securityincome, Szapiro found that nearly 62 percent of the saver’s incomewould be replaced in retirement from a Traditional 401(k), comparedto nearly 57 percent of income replaced by savings from a Roth401(k).

The difference is a nearly 8 percent drop in retirement incomefrom the Roth account, according to Szapiro’s research.

“This can be a big difference,” said Szapiro. “The income tradeoff between traditional and Roth accounts is not always an evensplit.”

Be cautious

Like other analysis, Morningstar’s data assumes tax rates remainthe same in retirement. That of course is not always the case,particularly with younger savers, many of whom can expect to seeearnings increase over the course of their careers. Under thatscenario, a Roth approach could benefit younger savers.

Under the level earnings assumption, middle-class savers wouldsee the largest reduction in retirement income under a shift toRoth.

Higher income earners, who would have a higher effective taxrate in retirement, could benefit from a shift to Roth accounts,Morningstar’s research shows.

And lower income workers could also benefit from a shift toRoth, given that many may not have federal income tax exposure.

Morningstar’s research adds a fresh wrinkle to the alreadycomplex debate over tax reform.

Tax-deferred contributions to traditional 401(k) plans representone of the largest so-called expenditures in the federal taxcode.

Defined contribution deferrals will cost the IRS about $102billion in foregone revenue in 2017, and about $584 billion between2016 and 2020, according to the Joint Committee on Taxation.

Traditional IRA contributions will cost another $16 billion inrevenue in 2017 and $86 billion between 2016 and 2020.

Congress recently authorized $1.5 trillion in tax cuts. Thequestion now is how to pay for them.

The first details on the tax proposal could come as early asthis month, as committees in both chambers of Congress are busilyputting the finer points on the White House’s pledge to deliver$1.5 trillion in tax cuts over the next decade.

The White House’s nine-page framework for reform, released lastmonth, added more ambiguity to a question that has roiledretirement industry stakeholders and consumer advocates since theelection of President Trump last year: Will lawmakers use theRothification of retirement plan contributions to help pay for taxcuts?

According to the White House’s framework, “tax reform will aimto maintain or raise retirement plan participation of workers andthe resources available for retirement.”

But the framework also eliminates most itemized deductions, savefor mortgage interest and charitable contributions.

Proposals to Rothify the country’s retirement savings system bycapping or eliminating the deductibility of contributions wouldmove long-term tax revenue into the 10-year budget window. TheJoint Committee on Taxation and the Congressional Budget Officewill score any proposed tax legislation based on its 10-year impacton the federal budget.

Much of the debate over Rothification has focused on thepotential impact on workers’ savings habits: Without the taxincentives to save, some may opt not to.

Some workers may lower savings rates to make up for lowertake-home income under a mandatory Roth savings system. That inturn could mean some would leave employer matches on the table.

In a recent Senate finance committee hearing, the prospect ofRothification met bipartisan skepticism.

But tapping revenue by transitioning to a Roth retirement systemwill no doubt remain an attractive option to some lawmakers underthe 10-year budget scoring system, said Szapiro.

“That would not be good for some savers,” he said. “I do thinkwe need to be cautious.”