The Trump administration sees lower tax rates as a key to economic growth. But that means lost tax revenue, which will likely have to be made up in other ways—including possibly cutting into 401(k) tax benefits. At present, the debate is still active and 401(k)s may be safe. But it’s important to understand the shape of the arguments.
In September, after months of negotiation, the administration and Republican leadership released a tax reform plan that would cut the corporate income tax rate from 35 percent to 20 percent. It would also reduce the number of tax brackets from seven to three: 12 percent, 25 percent and 35 percent, and it would double the standard deduction. Those efforts are expected to put a huge dent in the federal budget. Trimming individual tax rates alone could add $2.6 trillion to the national debt, according to an estimate by the Tax Policy Center, a nonpartisan Washington, D.C.–based think tank. Since then, both the House of Representatives and the Senate have come up with their own versions of the tax bill.
Making Up Lost Tax Revenue
Now the question is, how can Republicans revamp the tax code without breaking their pledge to make reforms revenue-neutral? Earlier this year, top members of the president’s economic team emphasized that the tax benefits attached to retirement plans weren’t on the chopping block. But subsequent statements haven’t been quite as reassuring. In July, Marc Short, the White House Legislative Affairs Director, acknowledged that retirement plans were part of the conversation. And the tax proposal the White House released on September 27 remained pretty vague on the issue: The plan, it said, “will aim to maintain or raise retirement plan participation of workers and the resources available for retirement.”
The fact is, few people outside of the White House know what is or isn’t on the table when it comes to offsetting the budget shortfall. “The open-ended language of the framework really signals that the Republicans are still trying to figure out what they are doing,” an American Benefits Council executive told Bloomberg.
Among the options: not allowing investors to deduct the full amount of their contribution and placing a freeze on the amount they can contribute each year. The idea that’s drawing the most attention, however, would require individuals to contribute to a Roth 401(k) rather than to a traditional account.
A traditional 401(k) allows investors to deduct a portion of their contributions from their taxes. However, when they retire, their withdrawals are subject to the ordinary income tax rate. Roth 401(k) accounts work in the opposite way. Workers contribute post-tax dollars, but are allowed to pull the money out tax-free after age 59½.
The so-called Rothification of retirement accounts would improve the government’s bottom line in the short run, because workers would no longer be able to postpone their tax liability. The Congressional Joint Committee on Taxation concludes that defined-contribution plans cost the government more than $580 billion over a five-year period. So capturing some of that revenue would go a long way to shore up the budget deficit.
The Impact on Taxpayers
The implications for taxpayers, though, are a bit more complicated. Theoretically, if an employee remained in the same tax bracket after retiring, the impact of a traditional and a Roth 401(k) would be identical. And if you contribute before you have reached your peak earning years—as is the case with a lot of younger folks—a Roth can actually result in a lower tax burden.
But the Roth-only model would hurt other Americans—those who expect to earn less, and thus fall into a lower tax bracket, when they retire. For this segment of the population, a traditional 401(k)—allowing one to reap tax rewards now versus later—makes more sense.
There’s also a fear that the changes could actually discourage Americans from using their 401(k). When people see taxes cut into their contribution (or don’t have the immediate tax-savings motivation to contribute), some experts suggest they may be less likely to use the account—even if they’re getting a sizable tax break later on.
Rothification also adds complexity. While worker contributions would be taxed up front, employer contributions would almost certainly still be treated as they are today. So a portion of money withdrawn in retirement would still be subject to income tax. For less savvy investors, making the differentiation between amounts that are taxable and those that aren’t could be a daunting task.
And from an employer’s perspective, a Roth-only approach would make it more expensive to administer 401(k)s. One survey found that as many as 30 percent of businesses would consider dropping their retirement plan should Rothification become law.
So while Roth accounts are a great choice for some employees, making it the only option for investors has some clear tradeoffs.
The Bottom Line
President Trump’s economic team faces tough challenges in reshaping our labyrinthine tax code, not the least of which is trying to make up for revenue lost due to rate cuts. As of now, it’s still not clear which way the changes will go.