Will 401(k) Plans Be 'Rothed'?

On the Docket This week, the Republican Party is expected to release its tax-reform proposal, crafted both by Congress and the White House administration. It is known that the GOP will reduce tax revenues by slashing the corporate rate, probably from 35% to 20% (the White House sought 15% but seems to have compromised) and by lowering the top marginal income-tax rate from 39.6% to 35%. Unclear, however, is which current tax benefits will be eliminated to pay for these tax cuts.

This year's effort, as with so many reform bills before it, has opted against shooting elephants. Companies won't pay a "border tax" on their imports, as the GOP had recommended earlier this year, and home-mortgage payments will continue to be tax protected, as will charitable donations. Consequently, the GOP's tax-reform plan won't be revenue-neutral, absent a heroic increase in GDP growth.

But that doesn't mean that the party isn't trying to close the revenue gap. One suggestion that the GOP has mulled, per Politico, is that 401(k) contributions lose their up-front tax shelter, so that the current year's plan investments would be made with aftertax money. This would boost federal revenues over the near term--although as we shall see, not over the long haul--and thereby improve the reform bill's 10-year projections.

Under such a proposal, initial 401(k) contributions would be taxed (although employer matches, should the company offer such a benefit, would continue to be untaxed at the time of the contribution), the investment gains would be tax-free (as is the case today), and the retirement withdrawals would also be untaxed. In short, 401(k) plans would cease to behave like traditional IRAs and would instead act as do Roth IRAs (once again, aside from company matches). Current 401(k) rules permit companies to offer a Roth-style option to their employees, should they so desire. The suggested legislation would make that option mandatory. The 401(k) structure would be Rothed.

Three questions:

1) Should this happen?

2) Will this happen?

3) If it does happen, what will be the outcome?

Should It? From the investment perspective, the answer leans toward "No."

This Morningstar video--don't skip the comments--discusses how both of the tax structures have their merits. As a very general rule, the current structure favors older, upper-income workers, who are likelier than their younger, lesser-paid counterparts to have a higher marginal tax bracket today than they will during retirement. They can defer taxes when they owe the most. In contrast, those who are beginning their careers, with entry-level salaries, should probably be Rothed.

However, as covered in this paper by Morningstar's Aron Szapiro (who dissects the 401(k)/Roth investment issues in greater detail), the traditional arrangement has one big investment advantage. Today's 401(k) contributions are exempt from taxes at the individual's highest marginal rate. In contrast, Roth payouts may give a tax benefit as low as on the effective rate--a different animal than the marginal rate. Thus, Rothing 401(k)s will often lead to somewhat lower overall tax benefits for the employee.

The psychological benefits are a wash. The up-front tax benefit makes the current approach an easier sell. If people didn't wish to take their pleasure now and delay their pain until later, getting them to save for retirement wouldn't be a chore in the first place. But they do, and thus the tax write-off is useful for sugaring the medicine. On the other hand, the Roth structure adds much-appreciated certainty of retirement planning. With a Roth 401(k), what the employee sees is exactly what the employee gets; future taxes are the known quantity of zero.

Will It? I would be surprised if such a proposal were to pass, so that all future 401(k) contributions become aftertax. Not shocked, but certainly surprised.

The reason being that the Democrats have two good responses. One is the valid criticism that switching 401(k) plans from being tax-protected now to tax-protected later consists of kicking the fiscal can down the road. The action only modestly increases federal revenues over the long haul. It is instead a political dodge that improves the near-term fiscal outlook, at the cost of the long term.

(As an Illinois resident who works in Chicago, I have learned all too much about fiscal shell games.)

The second assertion is less sound, but stronger rhetorically. It is that in moving to a Roth 401(k) approach, the GOP would take from the middle classes to give to corporations. As we have seen, that is not correct; the proposal delays the 401(k) tax benefit to employees but does not eliminate it. But who said that successful political claims must be accurate? (Also, it must be acknowledged, such an argument extends the GOP's own logic, as the GOP itself hatched the notion that changing the 401(k)'s structure would improve federal revenues.)

My colleague Szapiro, who closely monitors the Beltway beat, thinks that if the GOP were to advance the Roth-style scheme, and got challenged on populist grounds, that it could successfully respond by modifying the proposal so that it would apply only to higher-income employees. That way, everyday workers would preserve their current benefits, and the Democrats would be appeased.

So, that could happen. Although even the more modest proposal would face resistance from the investment-management industry, which would prefer to collect its assets earlier rather than later.

The Consequences? From a policy perspective, the big question is how employees would react if their 401(k) plans were suddenly Rothed. Most retirement-industry observers argue that removing the tax sweetener would devastate the 401(k) system, as current workers reduced their contributions, and future workers decided not to participate at all. That might well occur. However, such speculation is exactly that; there aren't real-world examples to guide us.

Also, if the switch to a Roth 401(k) approach were accompanied by stronger "nudges" to plan participants, for example stiffer exit barriers for those who were automatically enrolled in their company's plan and who wished to opt out, then much movement could probably be avoided. The history of 401(k) investing suggests that employees typically follow the path of least resistance. Make it easy for them to join and difficult to leave, and stay they probably will.

Of course, my argument is also speculation. Suffice it to say, should such legislation pass, the 401(k) system will require renewed, strengthened sales efforts--and likely some regulatory changes--so as to solidify participation. Paying taxes now or paying taxes later might not greatly affect the investment outcome--but dropping out of a plan most certainly would.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.