In the run up to the passage of the Tax Cuts and Jobs Act last December, the financial services industry waged a concerted lobbying effort to protect the tax-preferred status of contributions to qualified retirement accounts.
But in an ironic twist, the landmark bill that lowered the individual tax rates for most income brackets has indirectly made after-tax contributions to Roth plans more favorable for savers, say consultants from Willis Towers Watson.
“The corporate tax rates have gone down, but so have the individual tax rates,” Diane Nowak, a Cleveland-based plan consultant for WTW, said in a webinar hosted by the firm for plan sponsors. “Because of that, the Roth feature is much more appealing now.”
Capping the level of pre-tax contributions to 401(k)s and IRAs was floated by some Republican lawmakers as a way to offset lost revenue from lower corporate and individual rates, but the idea was cut from the negotiating table after a forceful tweet from President Trump.
A vast consortium of interest groups that ranged from AARP to the Investment Company Institute strenuously pushed back against the idea, arguing that the so-called Rothification of retirement plans would lead to lower savings rates if the incentive of saving pre-tax dollars was lowered or removed.
But while the TCJA made the lower corporate tax rate permanent, the cuts to individual rates are scheduled to sunset in 2026, when rates will revert to previous levels. Lawmakers needed to make the individual rate cuts temporary in order to keep the cost of the bill under $1.5 trillion in the 10-year budget window.
“If you expect tax rates to go up, you would want to contribute to your Roth feature now–that’s the situation we are in until 2026,” added Nowak. “For the vast majority of us, tax rates will go up.”
A survey of Towers’ clients shows 70 percent of plans offer a Roth savings option, up from 46 percent in 2012. Those that don’t cited low demand and employee confusion as reasons for not implementing the option.
“We think there is an opportunity now for employers to help employees with those decisions based on the current environment,” added Nowak, who said those employers that don’t offer a Roth feature would be advised to consider adding the option.
Other analysis from Towers shows a large percentage of savers—nearly half—will see their marginal tax rate increase in retirement. And half will see their rates stay the same, conditions that further encourage the Roth savings strategy. Distributions from Roth plans in retirement are not taxed, while distributions from traditional retirement plans are taxed as ordinary income.
Putting HSAs first may be most efficient savings strategy
Eight in 10 employers surveyed by Willis Towers Watson now offer a health savings account paired with a qualifying high-deductible health care plan, up from 59 percent in 2014.
HSAs come with a three-pronged tax advantage, offering the advantages of both traditional and Roth retirement plans—contributions to HSAs are pre-tax, investments grow tax-free, and distributions from the accounts for qualifying health care costs are tax-free.
In 2018, the cap on contributions to HSAs for individuals is $3,450; the cap for family plans is $6,900. Catch up contributions of an extra $1,000 are allowed for participants age 55 and older.
Their tax efficiency is unmatched by any other savings vehicle, said WTW’s consultants.
“Health care costs are going up and we are all concerned about paying for those costs post retirement,” said Nowak.
Most plan participants are prioritizing 401(k) deferrals over HSAs, but the consultants said that strategy needs to be reexamined.
“The message should be putting money into an HSA first makes sense if you have limited disposable income,” said Nowak. “Maxing out HSAs first is the rule of thumb to follow.”
Prioritizing HSA contributions would mark a dramatic sea change in plan sponsors’ and participants’ existing approach to retirement saving. Nowak said plan participants should be cognizant of saving enough in retirement plans to earn employer-matching contributions, but also noted that some employers are offering matching contributions to HSAs.
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