Tapping the tax-preferred status of employer-provided retirement plans and traditional IRAs to fund tax reform is not a new idea.
But as the Trump administration and Congressional Republicans are under political pressure to deliver on tax reform before the 2018 mid-term primary season, this time around the prospect of Rothifying all or some portion of the retirement system is different, says Jessica Sclafani, an associate director at analytics firms Cerulli Associates.
“The idea has been lurking out there, but now it is being taken more seriously as an option for tax reform,” Sclafani told BenefitsPRO.
According to the Joint Committee on Taxation, defined contribution deferrals will cost the IRS about $102 billion in foregone revenue in 2017, and about $584 billion between 2016 and 2020.
Traditional IRA contributions will cost another $16 billion in revenue in 2017, and $86 billion between 2016 and 2020.
The White House’s Office of Management and Budget ranks the tax preferences on traditional defined contribution plans as the fifth largest expenditure in the federal tax code. OMB says the tax deferrals on 401(k) and other qualified employer-sponsored plans will cost $958 billion between 2017 and 2026.
While details on reform proposals are scant, White House officials continue to pledge to have a tax bill on the floor by the end of the year.
The White House has made repeated assertions that deductions on charitable giving and mortgage interest will be preserved. Less definitive pledges have been given to the deductibility of retirement savings contributions.
Under House Republicans’ blueprint for tax reform—a guideline reportedly being considered as a formal proposal is crafted—individual tax rates would be reduced to 12, 25, and 33 percent. That alone would cost between $1.5 trillion and $2 trillion in lost revenue to the government over a decade, according to data cited by the Committee for a Responsible Federal Budget.
Cerulli’s Sclafani underscores what other retirement advocates and policy experts have told BenefitsPRO and other media outlets: the tax-deferred status of traditional defined contribution plans is clearly on the table.
“I think for a long time industry was flat out opposed to the idea, but now there is a sense it might happen,” she added.
That is why Cerulli is recommending that record-keepers and plan consultants prepare a preemptive plan as policy discussions ramp up on Capitol Hill.
In the most recent edition of the Cerulli Edge, the firm’s analysts say plan providers should be preparing to advocate that a switch to a fully Roth system be implemented on a non-elective basis.
That would mean that participants would not be required to confirm their existing deferral rate if plans were transitioned to Roth platforms on a compulsory basis.
“If they were required to confirm their deferral rates, that would give participants the opportunity to reduce savings,” explained Sclafani. “We want to eliminate that opportunity.”
Because the potential of Rothification is real—if not certain—Sclafani says industry would be best positioned to be ready with its “asks,” or ideas in hand for lawmakers to offset the possibility that Rothifying DC plans could lead to lower contribution levels.
Lower tax rates, in accord with the elimination of popular tax deductions, could have the effect of bumping some of the workforce into a higher tax bracket, said Sclafani.
“The Trump tax plan is being framed as a tax cut for middle-class Americans, but at this point we are not sure how it will work out for some individuals—there is a possibility some will end up in a higher tax bracket,” she added.
Stretch the match
If individuals see their tax exposure increase under reform, and their take-home pay reduced, they may be more inclined to reduce their retirement savings contributions.
One way for providers to combat that possibility is to further emphasize the role of employer matching contributions as an incentive for higher savings rates, Cerulli says.
Optimizing match formulas could counteract participants’ impulse to lower savings rates.
Cerulli advocates implementing a “stretch match” formula, as opposed to a dollar-for-dollar match formula, commonly deployed by plan sponsors.
An example of a stretch match would be offering 50 cents on the dollar for every dollar participants contribute up to 6 percent of pay, as opposed to a dollar-for-dollar match on 3 percent of pay.
“Data shows that participants are motivated to save enough to get the company match—they don’t want to leave free money on the table,” said Sclafani.
“That reality becomes even more important if tax reform exerts downward pressure on plan contributions,” she said. “The match can act as deferral floor.”
Tax reform could mean a pay raise for some
A reformed individual code with low lower rates could translate into an effective pay increase for some in the middle class, notes Cerulli.
“This situation presents an opportunity for record-keepers to get in front of these individuals and urge them to increase their contribution rate,” say the firm’s analysts.
In a recent survey of 1,000 plan participants, Cerulli found that over half said a pay raise or bonus is a motivating factor to increase savings rates.
But the survey also found the vast of majority of savers are clueless on how Roth plan contributions are taxed.
Only one-third could accurately identify the benefits of investing on an after tax basis, including the fact that withdrawals in retirement are tax-free.
The learning curve improves for higher earners—among those making more than $91,000, 44 percent correctly identified Roth plans’ characteristics.
One quarter of all savers admitted to not knowing Roth features. Nearly 20 percent mistakenly said Roth contributions are made on a pre-tax basis, and the withdrawals are tax-free. Another 14 percent inaccurately said savings are taxed in retirement.