There are many moving parts in the tax proposal, but in an all-Roth world, where you fund your retirement savings with after-tax dollars, lower-income workers might struggle with their cash flow. Higher-income workers could feel the effect more in the loss of the current tax break that traditional 401(k)s provide to lessen current taxable income.
Discussions appear to be in the early stages, and any move to favor Roth 401(k)s or IRAs could come with other savings options as part of the mix.
“401(ks) are a critical savings tool for workers, and we are looking to grow more savings in America,” a spokesperson for the House Ways and Means Committee said in an email. “We’re considering solutions that increase the number of people using 401(k)s and other savings vehicles.”
Roth 401(k)s are becoming a more common option in retirement plans. A Roth option was in 60 percent of Vanguard plans as of the end of 2015, up from 46 percent in 2011. Fifteen percent of participants were using the option, according to Vanguard’s “How America Saves” report for 2016. Vanguard doesn’t provide a breakout showing what percentage of assets are in Roth 401(k), but the vast majority of the money is in regular plans.
One proposal being bandied about is a 50-50 split between allowed pretax and post-tax contributions, said Will Hansen, senior vice president for retirement policy at the Erisa Industry Committee (ERIC), a trade association for large employers that deals with employee benefits and compensation issues. Hansen has also heard talk of “a lower limit like $2,500 or $5,000 for pretax and the remaining money goes into a Roth,” as well as discussions about increasing the annual contribution limits to a Roth 401(k) from $18,000 to the $20,000’s, which would appeal to wealthier savers.
The ideas floated on Capitol Hill have included “certainly an all-Roth option, discussion about capping 401(k) contributions based on one’s income, and conversations about a hybrid-type solution involving pretax and post-tax contributions,” said Edmund Murphy, chief executive officer of Empower Retirement, one of the largest retirement plan providers. Murphy doesn’t expect a move to an all after-tax system, noting that an all-Roth plan could discourage savers.
At the Employee Benefit Research Institute, Research Director Jack VanDerhei said "a large percentage" of the group’s members in the defined-contribution world have called to talk about the “potential Roth-exclusivity of 401(k) contributions.”
A likelier outcome from the talks is a hybrid system, such as the ones Hansen and Murphy mentioned. One way to go is to make the first X percent pretax and the next Y percent after-tax, Murphy said. That might not be so bad, according to one study, “Tax Uncertainty and Retirement Savings Diversification.” The study looked at optimal savings strategies for investors able to contribute to both Roth and traditional 401(k)s, and ran a large simulation that found most investors had a better outcome when they had assets in both. It noted that “Roth investments allow investors to eliminate tax risk on a portion of retirement savings.”
A hybrid system might run along the lines of what former House Ways and Means Chairman Dave Camp, a Republican from Michigan, suggested in a 2014 tax plan. To finance cuts in individual tax rates, Camp urged an emphasis on Roth IRAs vs. traditional retirement savings accounts. His plan would have converted “some excludable 401(k) contributions to Roth-style retirement accounts for those contributing more than $8,750” that year, according to a Tax Foundation analysis.
By letting you contribute pretax money, traditional 401(k)s lower your current tax bill. Earnings compound tax-free until, in the case of 401(k)s, you tap the fund without penalty, which you can do when you turn 59½, or when you must start tapping it, at 70½. You pay taxes on any withdrawals at your regular income tax rate. With Roth 401(k)s, funded with after-tax money, earnings also compound tax-free, but you withdraw the money without paying any further taxes on it.