Is ‘Rothification’ Coming for Your Retirement Account?

The last election was not fought over tax policy, but now that it is over, it’s a safe bet that you will hear a lot about tax ideas that could dramatically change the attractiveness of some US investment strategies over the next two years.

This focus on taxes is deadline-driven. Except for the corporate business tax adjustments, the provisions of the Tax Cuts and Jobs Act of 2017 expire at the end of 2025, forcing a rare need to vote on tax policy. As has been the case before, we expect that there will be extensive conversations about the tax incentives for the US retirement system.

Why this confident prediction? The tax incentives for retirement savings will cost the government more than $1 trillion in forgone revenue over the next 10 years. There are also trillions in expensive new tax priorities that members of both parties want to see passed into law. In combination, it’s easy to see why members of Congress will start to explore restricting or even ending some tax benefits for retirement savings.

Enter the likely solution of choice: “Rothification.”

As a refresher, Roth contributions are after taxes. So, when contributing to a Roth IRA or 401(k), participants pay taxes on money before they contribute it to those retirement accounts. Then, the money grows tax-free and comes out tax-free.

In contrast, a traditional IRA or 401(k) contribution is made before taxes, and the taxes are collected by the government when the money is withdrawn.

“Rothification” refers to a policy shift requiring the use of aftertax, or Roth, accounts, which means that plan participants would pay taxes before contributing to their retirement plans. That, in turn, would mean that the federal government could collect a lot more in taxes, at least in the short term (around $1 trillion over 10 years by some estimates).

Of course, such a change ultimately means lost revenue later, but most revenue bills are “scored” (that is, evaluated for the estimated impact they will have on government spending and collections) for 10 years, and most of the lost revenue is outside of that window.

Why Is Rothification So Bad? And for Whom?

Many people already voluntarily contribute to Roth accounts, and for some people they make sense.

The basic bargain that a Roth option offers is this: Trade between saving on taxes today or saving on them in retirement. (To be more technical, it’s also typically a trade between saving on a marginal versus an effective tax rate, but more on that in a second.)

For lower-income workers whose salaries and standards of living may improve in the future, Rothification may make sense. After all, they pay a small tax today and could avoid a higher tax rate tomorrow.

But there are lots of reasons to be skeptical.

• First, for many Americans, putting all their retirement savings in Roth vehicles is likely a negative. After all, most people live on less income in retirement, so it would be ultimately more burdensome to have a higher tax bill then.
• Second, effective tax rates are always lower than marginal tax rates if tax brackets remain fixed. (Of course they won’t, but they may not change that much.) In a progressive tax system like we have in America, any additional income earned is taxed at the highest bracket, or the marginal rate. The effective rate is the blended rate across all tax brackets. When workers direct their salary into a traditional 401(k), they save on their marginal rate. When they use a Roth option, they pay their marginal rate, but they save on the effective rate of taxes they would have paid on the Roth accounts when they draw them down in retirement.
• Finally, and perhaps most importantly, the potential tax benefits for Roth accounts only work out if the US maintains its tax system in the future. If we shift to a broader-based sales tax, raising more money through tariffs, or dozens of other plausible changes in how federal, state, and local governments raise revenue, the Roth benefits might be worth much less in the future.

As a coda, since Rothification doesn’t actually generate more tax revenue over the long term, it’s entirely possible that the government will need to find other ways to raise taxes in the future, potentially negating the benefits of a Roth account.

Concluding Thoughts

There is no compelling policy reason to require Roth-designated contributions other than to play games with the budget scoring. While some people would surely benefit, many people might not.

We will do more modeling on these proposals if conversations around Rothification heat up in Washington, which is something to watch out for.