The battle for tax reform has begun. In a Wednesday night speech, President Trump called for a rewrite of the tax code. How this campaign plays out is anyone’s guess today.
How this might impact you and your retirement savings? One outcome could cost you plenty by ending the tax break that you now enjoy on contributions to a regular 401(k) account. Now, you get a tax deduction on that money and it is not counted as part of your taxable income.
But those benefits would end if Congress changes 401(k) rules so that your contributions do count as part of your taxable income. It would do that to pay for other tax cuts. On Wednesday, Trump spoke at length about his desire for corporate tax cuts. He spoke fleetingly of personal tax cuts.
What Could Change
In the bigger war over tax reform, one of many tax rules that Congress may battle over involves one of the pillars of retirement planning for millions of Americans, the tax deduction that workers receive when they put part of their pay into a 401(k) plan account. “Many people in the retirement savings business are concerned that one way Congress might choose to pay for certain tax cuts is by eliminating the upfront tax break on contributions to 401(k) accounts,” said Dennis Simmons, executive director of the Committee on Investment of Employee Benefit Assets (CIEBA). CIEBA’s members are the chief investment officers and other managers of large pension and 401(k)-style retirement plans.
Such a change could take the form of Rothifying 401(k) accounts — that is, forcing all 401(k) accounts to function the way only Roth 401(k)s and Roth IRAs do now. Contributions to regular 401(k) accounts would no longer escape being taxed as ordinary income.
In regular 401(k) accounts and IRAs now, workers get tax deductions on their contributions. Those contributions are not counted as part of their taxable income for the year. That’s why they are known as pretax contributions.
In contrast, contributions to Roth 401(k) accounts and to Roth IRAs are after-tax contributions. They are not excluded from your taxable income calculation.
Also unlike traditional 401(k) accounts and IRAs, money you withdraw from Roth accounts is tax-free after five years and you reach age 59-1/2.
One thing that works the same with either type of retirement account: earnings that stay inside either regular or Roth 401(k)s or IRAs grow without being taxed.
Converting all 401(k) accounts to Roth rules would recapture a lot of tax revenue that advocates of such a move call lost. A report by the U.S. House and Senate’s Joint Committee on Taxation estimates that 401(k)-style retirement plans will cost the government $583.6 billion between 2016 and 2020.
Recapturing that would help pay for tax cuts elsewhere.
CIEBA’s Simmons says that singling out those $583.6 billion would be unfair. “They’re not ‘lost’ taxes,” he said. “Workers do pay taxes on those contributions once they withdraw the money in retirement.”
In contrast, funds from tax breaks such as the deductibility of mortgage interest payments and of state and local taxes are truly lost forever to the U.S. Treasury.
Members of CIEBA, which represents retirement plan interests before Congress, regulators and the media, cited in a survey several downsides to Rothification of 401(k) plans. One is that it probably will lead many workers to stop contributing to their accounts. A whopping 78% said that would be likely. “The upfront tax benefits are a big reason why many plan participants contribute,” Simmons said. “Without those benefits, many participants would not see sufficient reason to participate.”
Rothification would also force employers to go through a costly and time consuming re-education effort. Eighty-two percent of CIEBA members said the new communications would be difficult.
“There’s a danger that many small companies would stop offering 401(k) plans altogether,” Simmons said.
And 96% said workers in their plans would view such a change negatively.
Seventy-four percent of CIEBA members offer Roth options in their 401(k) plans already. But on average only 10% of plan members bother to use them. “That shows limited interest in Roth accounts,” Simmons said.
The bottom line? “This (Rothification) change would have a materially adverse impact on savings. The complexity (for both plan sponsors and members) would be pretty extreme. It would be throwing a bomb into a system that, with auto-enrollment, works well today.”
Reprint from Investor’s Business Daily.