Tax Reform Prospects Should Spur a Closer Look at Roth Retirement Savings Plans

When the hurly-burly’s done, 
When the battle’s lost and won…

          – Macbeth, Act I, Scene I.

So answers the Second Witch in the opening scene of the “Scottish play” of Shakespeare, to the First Witch’s query:  when shall be the weird sisters’ fateful meeting with Macbeth?  At that meeting, foreshadowing Macbeth’s rise to kingship (Act I, Scene III), it is clear that the witches are in the prediction business – as now must be American taxpayers anticipating some form of the Trump Administration’s tax reform proposals becoming law.

Among the many vexing problems with taxpayers’ planning is:  What changes will be made in the rules for the tax-favored retirement savings?  The estimated $115 billion per year of tax expenditures on retirement savings in the federal budget is perhaps the most tempting target for realization of tax savings needed to pay for the Trump tax plan’s ambitious business and personal tax cuts.  All the more so now, in the wake of evident resistance among urban state Republicans to initial proposals for cutback or elimination of the present deduction for state and local income and property taxes.  

Not long after an October 20 Wall Street Journal article’s title trumpeted:  “Talk of Retirement-Savings Cap Ruffles Financial Industry,” President Trump sought to reassure voters that 401(k) plans will be preserved.  Leaders in the House thus far have resisted being bound to this, and as yet the details of a tax bill are still in the opaque blur of the crystal ball.  Nevertheless it is a good time for taxpayers, both employers and individuals, to take a closer look at the current retirement savings vehicles – “traditional” and “Roth” 401(k) plans and IRAs, and changes that might emerge.

The focus of the Wall Street Journal article was a proposal to cut drastically the maximum allowed yearly contribution to a pre-tax (“traditional”) 401(k) plan account – from the $18,500 that will be allowed for 2018 ($24,500 for those age 50 or more in the taxable year) to just $2,400 annually.  Presently under the proposal, the $18,500 (or $24,500), indexed maximum apparently would remain as an overall limit, but any amounts contributed above $2,400 would be required to be after-tax (“Roth”) contributions.  It is uncertain whether the lower pre-tax limit would also apply to IRAs (which have $5,500 and $6,500 caps for the same age groups) but it is reasonable to assume that it would.

As background:  In the pre-tax 401(k) or IRA, the participant gets an upfront tax deduction for the contribution taxes must be paid on 100% of the account – contributions plus earnings – when funds are later withdrawn.  After-tax Roth works the opposite way – there is no upfront tax deduction but 100% of the account – contributions plus growth – is tax-free when withdrawn.  Because that “when withdrawn” time may be years – maybe decades – after the concomitant contribution was made (viewing the account on a first in – first out basis), the value of the 401(k) or IRA tax benefit is not so much the value of the tax deduction as it is the value of the exemption from tax of trust earnings during the course of the participant’s use of the retirement savings account.  In a participation span of, say, 30 years, this may cause earnings – the “inside buildup,” to use an insurance term, to constitute 75% or even 80% of the value of the account when funds are first withdrawn.  If the participant’s marginal tax rate at time of contribution(s) is the same as it is at the time of withdrawal(s), and there are no variations in earnings rates at different times of contributions and withdrawals, the comparison of the ultimate value of pre-tax traditional and after-tax Roth retirement accounts is a wash.  However, that state of affairs is highly improbable over any lengthy period of retirement savings.

The advantage of one or the other of the pre-tax or Roth schemes emerges principally from comparing marginal tax rates at time of contribution against almost-surely different marginal rates upon withdrawal.  Putting earnings rates and duration of savings aside, if the participant’s marginal tax rate is lower at contribution than at later withdrawal, the after-tax Roth scheme would appear to produce superior ultimate value.  Conversely, if the participant expects later to withdraw retirement funds paying marginal income taxes at a lower rate (i.e., a higher marginal rate applied when contributions were made), then the pre-tax traditional scheme would likely provide more value.  

In the above simple examples, we have not only ignored variable contribution amounts and earnings rates over an uncertain number of years of retirement savings efforts, we have also not yet accounted for what else may result from this new tax law and others in the future – changes in individual and business tax rates, including a possible drop of pass-through entity marginal tax rates to 25%.  Of all the factors we have discussed, this is the one that looks most like whatever it is that is bubbling in the witches’ cauldron.  And what could be bubbling may prove to be changes that may dampen employer incentives to maintain retirement savings plans, and may force 401(k) participants and IRA owners more in the Roth direction by more limited pre-tax retirement contributions, whether cut as drastically as above or not.

This should prompt retirement savers to take a second look at current behavior, which vastly favors the “bird-in-hand” approach of pre-tax 401(k) and IRA retirement savings.  Some data have suggested that participants, particularly lower-paid participants who would benefit more from Roth, do not especially like the Roth approach.  By and large the Roth alternative has appeared to be under-utilized in most 401(k) plans that have added Roth to pre-tax contributions.  This comes not only from the desire to eat the tax-deduction candy now – but also, and particularly at times of tax-law change, from the justifiable worry that the “Roth promise” of 100% tax-free withdrawals may not be kept in later years when the funds are taken out of the plans.  (The greater likelihood is that existing Roth savings at the time of a future adverse law change would be protected or grandfathered).  With that uncertainty, it may appear foolish to a participant to pay a tax on the contribution before he or she has to, even apart from the greater out-of-pocket upfront cost of the Roth contribution.

Nevertheless, the Roth scheme has certain potential advantages over pre-tax 401(k) or IRA savings well worth consideration by participants at all earnings levels who may still have many years to accumulate retirement savings.  The most significant Roth advantages are:  (1) Roth IRAs (into which Roth 401(k) accounts may be rolled over) are not subject to post-age 70½ required minimum distributions (RMDs), unlike all 401(k) plan savings, so these funds may be preserved intact to the end of life and passed on even to non-spouse  beneficiaries through an inherited Roth IRA; and (2) Roth savings – both 401(k) and IRA – when distributed to a taxpayer do not count against the taxable income limits above which up to 85% of Social Security benefits paid to the taxpayer are subject to federal income taxes.  (All distributions of pre-tax retirement savings count against the income maximum for Social Security taxation).  This can be a powerful retirement savings advantage in Roth for anyone who anticipates working into the years in which he or she will also be collecting Social Security.  

It is to this time just before retirement – a time that in everyone’s life seems to come sooner than planned for – that retirement savers may wish to cast their thoughts when deciding to use a Roth or a pre-tax 401(k) plan or IRA alternative, or some combination of the two.  That is the time when the “hurly-burly” of the working (and savings accumulation) life is done – when the “battle” for wise retirement savings and investment has been “lost and won.”  (Both, because decisions along the way will invariably be some right, some wrong).  It is difficult if not impossible for anyone to predict years or decades before retirement how much in retirement savings he or she will end up with or what the tax laws will then be.  Even so, it needs no speculation to realize that at that future time, standing on the actual precipice of reliance on drawing out retirement savings, just about anyone would be happier if at least some of those retirement savings are Roth funds that can be withdrawn and used, or passed on to beneficiaries, tax-free.