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Will Tax Reform Hit Retirement Contributions?

A mandated shift to Roth-style plans would harm middle-class workers.

Aron Szapiro, 08/08/2017

The U.S. Congress and White House are talking seriously about passing a major tax-reform package. If they do, what can ordinary investors expect? Due to arcane budget rules, they likely can anticipate that a new emphasis on Roth-style retirement savings will be part of the discussion.

Major tax reform is tough—the last successful effort was in 1986 and before that in 1954. Recent history has not revealed much enthusiasm among members of Congress for the tough choices involved in a large tax-code overhaul. Yet, many experts think 2017 might be the year.

Republicans have offered some clear high-level principles for tax reform, such as reducing marginal tax rates while shrinking deductions and credits, but they have largely left specifics about retirement plans out of their early plans. For example, House Speaker Paul Ryan’s “Better Way” plan would lower the number of tax brackets to three from seven and reduce the marginal tax rates on those brackets, while making changes that would limit the number of people taking itemized deductions to around 5% of taxpayers. Further, the Ryan plan would try to encourage savings and investment in general— not just in retirement accounts—by reducing taxes on investment income.

Retirement Policy Is Important to Any Tax-Reform Plan
Still, changes to the tax treatment of retirement savings must be part of tax reform, even if there are few clear details yet to emerge. That’s because the “tax expenditures” on retirement contributions are among the highest in the tax code, at more than $100 billion annually, according to the U.S. Treasury. A tax expenditure is the amount the government “spends” by letting people or corporations reduce their taxes for various activities. The largest tax expenditures are for healthcare and mortgage interest, followed by traditional contributions to retirement vehicles such as 401(k) plans and IRAs.

Of course, the retirement tax expenditure is a little different from other tax expenditures because the government will collect taxes on traditional retirement savings someday. Traditional retirement savings are taxed in the future when people draw them down for retirement. However, because of the 10-year budget-scoring window, when the Joint Committee on Taxation and the Congressional Budget Office score this tax revenue, this future government revenue is mostly excluded.

10-Year Budget-Scoring Doesn’t Work for Retirement
The 10-year scoring window is just what it sounds like: Congress evaluates the effects of changes in the tax code based on revenue projections for the next 10 years, and typically no further. This makes a lot of sense for most policy evaluation. The CBO and the Joint Committee on Taxation cannot accurately predict further than 10 years into the future (let alone even 10 years into the future), making such efforts ridiculous. At the same time, at least trying to make these predictions forces policymakers to consider the medium-term impact of their legislation, which is important. So, 10-year scoring generally makes sense.

Unfortunately, 10-year scoring can have major distortionary effects on policymaking for retirement-savings incentives.

The reason is that 10-year scoring will show large tax expenditures for traditional retirement contributions but not for Roth contributions. Any shift toward Roth, in which the taxes are paid immediately on contributions but not on withdrawals, will generally create more revenue inside the 10-year window. Any shift toward traditional contributions, which are tax-deferred, will decrease revenue. Because Congress wants more revenue to offset other tax changes, increasing Roth contributions and decreasing traditional contributions will be very appealing to legislators trying to find a way to accomplish the medium-term goals of tax reform.

Aron Szapiro is a policy and finance expert with HelloWallet, a Morningstar subsidiary.

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