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New Tax Policy Changes Likely to Include Shift to Roth Contributions

Aron Szapiro

 

With a new Republican president, Republicans on Capitol Hill are seriously talking about passing a major tax reform package. Of course, passing major tax reform is difficult and has not been done since 1986. However, tax reform is a top priority for congressional Republicans this year. What the package could mean to ordinary investors remains uncertain. But, if a reform moves forward, I think we can expect a shortsighted emphasis on Roth-style retirement savings.

Tax treatment of retirement savings

While few details are clear, new tax policy for retirement savings will likely have to be part of tax reform. That's because tax expenditures on retirement contributions are among the largest in the tax code, at over $100 billion annually, according to the U.S. Department of the Treasury. Tax expenditures are the amount the government "spends" by letting people or corporations reduce their taxes for various expenses. The largest tax expenditures are for employer-sponsored health insurance and home mortgage interest, followed by traditional contributions to retirement vehicles such as 401(k) plans.

The retirement tax expenditure is a little different from other tax expenditures, because the government will collect revenue on retirement savings someday. After all, traditional retirement savings are taxed in the future when people draw them down for retirement. Nonetheless, the way that these tax revenues are estimated by the Joint Committee on Taxation (and Congressional Budget Office) mostly don't include these future government revenues.

Predictions and policymaking

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 sense for most policy evaluation. The Congressional Budget Office and the Joint Committee on Taxation cannot accurately make predictions more than 10 years into the future (or even 10 years into the future). At the same time, steering policymakers to continue the medium-term impact of their legislation is important. So, 10-year scoring generally makes sense—except when it comes to retirement policy.

The reason is that 10-year scoring will show large tax expenditures for traditional retirement contributions and not for Roth contributions. Any shift toward Roth, in which the taxes are paid immediately on contributions, will generally create more revenue inside the 10-year window. Any shift toward traditional contributions will decrease revenue. Because Congress wants more revenue to offset other tax changes, Roths will win the day. What form this shift will take is something to monitor going forward.

Is the shift to Roth contributions good or bad?

Probably bad. Roths are theoretically good for low-income people who have low tax rates today. But in practice, many of these people need immediate tax savings to help make ends meet and save a reasonable amount for retirement. And, even low earners may well have lower tax rates in retirement, particularly when we consider the way Social Security benefits are taxed at lower rates for lower earners, reducing the value of Roth contributions. Higher-earners will almost certainly be hurt by this shift, since most of them will live on lower replacement rates in retirement.

The blog post is adapted from an article that originally appeared in the Q2 2017 issue of the Asset Management Quarterly. Read the full article.

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