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

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

Much of the conventional wisdom in the retirement industry has assumed that 401(k) savings plans, whether designed on the traditional pre-tax basis, or the Roth after-tax basis, yield similar levels of retirement income.

But new analysis from Morningstar shows that for some middle-class wage earners, a Roth savings strategy can yield less retirement income.

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

A recent study published in the Harvard Business Review found that savers in Roth accounts did not lower their contribution rates.

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

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

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

But Morningstar’s Szapiro says those and other approaches to estimating the retirement income that Roth and Traditional accounts generate fail to calculate a subtle, but important, distinction in the tax code: the difference between the marginal tax rate and effective tax rate.

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

When savers contribute to Roth accounts, the contributions are taxed, but in many cases at a savers’ effective tax rate, which is almost 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 25 percent.

The saver contributes 10 percent of income to a Traditional 401(k), but reduces the contribution to 7.5 percent in her Roth account so as not to lower her take-home pay.

When applying level rates of investment return and drawdown strategies in retirement, and accounting for Social Security income, Szapiro found that nearly 62 percent of the saver’s income would be replaced in retirement from a Traditional 401(k), compared to nearly 57 percent of income replaced by savings from a Roth 401(k).

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

“This can be a big difference,” said Szapiro. “The income trade off between traditional and Roth accounts is not always an even split.”

Be cautious

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

Under the level earnings assumption, middle-class savers would see the largest reduction in retirement income under a shift to Roth.

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

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

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

Tax-deferred contributions to traditional 401(k) plans represent one of the largest so-called expenditures in the federal tax code.

Defined contribution deferrals will cost the IRS about $102 billion in foregone revenue in 2017, and about $584 billion between 2016 and 2020, according to the Joint Committee on Taxation.

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

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

The first details on the tax proposal could come as early as this month, as committees in both chambers of Congress are busily putting 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 last month, added more ambiguity to a question that has roiled retirement industry stakeholders and consumer advocates since the election of President Trump last year: Will lawmakers use the Rothification of retirement plan contributions to help pay for tax cuts?

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

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

Proposals to Rothify the country’s retirement savings system by capping or eliminating the deductibility of contributions would move long-term tax revenue into the 10-year budget window. The Joint Committee on Taxation and the Congressional Budget Office will score any proposed tax legislation based on its 10-year impact on the federal budget.

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

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

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

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

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