Morningstar Magazine - August/September 2017 - 16

Dispatches

Will Tax Reform Hit
Retirement
Contributions?
A mandated shift
to Roth-style
plans would harm
middle-class workers.

POLICY

Aron Szapiro

The U.S. Congress and White House are talking
seriously about passing a major tax-reform
package. If they do, what can ordinary investors
expect? Due to arcane budget rules, they
likely can anticipate that a new emphasis on
Roth-style retirement savings will be part
of the discussion.
Major tax reform is tough-the last successful
effort was in 1986 and before that in 1954.
Recent history has not revealed much enthusiasm
among members of Congress for the tough
choices involved in a large tax-code overhaul. Yet,
many experts think 2017 might be the year.
Republicans have offered some clear high-level
principles for tax reform, such as reducing
marginal tax rates while shrinking deductions and
credits, but they have largely left specifics
about retirement plans out of their early plans.
For example, House Speaker Paul Ryan's "Better
Way" plan would lower the number of tax
brackets to three from seven and reduce the
marginal tax rates on those brackets, while making
changes that would limit the number of
people taking itemized deductions to around 5%
of taxpayers. Further, the Ryan plan would try
to encourage savings and investment in general-
not just in retirement accounts-by reducing taxes
on investment income.

Morningstar August/September 2017

Retirement Policy Is Important to Any
Tax-Reform Plan

Still, changes to the tax treatment of retirement
savings must be part of tax reform, even if
there are few clear details yet to emerge. That's
because the "tax expenditures" on retirement
contributions are among the highest in the
tax code, at more than $100 billion annually,
according to the U.S. Treasury. A tax expenditure
is the amount the government "spends" by letting
people or corporations reduce their taxes for
various activities. The largest tax expenditures are
for healthcare and mortgage interest, followed
by traditional contributions to retirement vehicles
such as 401(k) plans and IRAs.
Of course, the retirement tax expenditure is a
little different from other tax expenditures because
the government will collect taxes on traditional
retirement savings someday. Traditional retirement
savings are taxed in the future when people
draw them down for retirement. However, because
of the 10-year budget-scoring window,
when the Joint Committee on Taxation and the
Congressional Budget Office score this
tax revenue, this future government revenue
is mostly excluded.

shift toward Roth, in which the taxes are
paid immediately on contributions but not on
withdrawals, will generally create more revenue
inside the 10-year window. Any shift toward
traditional contributions, which are tax-deferred,
will decrease revenue. Because Congress
wants more revenue to offset other tax changes,
increasing Roth contributions and decreasing
traditional contributions will be very appealing
to legislators trying to find a way to accomplish the
medium-term goals of tax reform.
Possible Approaches

At this time, there are no concrete proposals
on tax treatments for 401(k)s or other retirement
savings. However, there is some recent precedent
for a shift to Roths.

10-Year Budget-Scoring Doesn't Work
for Retirement

In 2014, then-U.S. Rep. Dave Camp, R-Mich.,
introduced H.R.1, a major tax reform bill that would
have simply required that all contributions
to employer-sponsored plans above $8,750 be Roth
contributions. Assuming this plan were updated
in 2017 dollars, it would require that all
contributions in excess of $9,000 be designated as
Roth contributions. (For the technical-minded
reader, the law used one half of the 402(g)
limits as the limit on pretax contributions, and
it would also extend the limit for one half
of catch-up contributions.)

The 10-year scoring window is just what it sounds
like: Congress evaluates the effects of changes
in the tax code based on revenue projections
for the next 10 years, and typically no further. This
makes a lot of sense for most policy evaluation.
The CBO and the Joint Committee on Taxation
cannot accurately predict further than 10 years into
the future (let alone even 10 years into the future),
making such efforts ridiculous. At the same
time, at least trying to make these predictions
forces policymakers to consider the mediumterm impact of their legislation, which is important.
So, 10-year scoring generally makes sense.

Obviously, that plan failed to become law, but
it reveals the interest lawmakers have in exploring
a shift to Roth contributions. While that plan
would have affected fewer than 20% of taxpayers,
it is very possible that Congress could go
further and simply require all future contributions
to be Roth-designated. In either case, employer
contributions to retirement plans would likely
still be deductible as a business expense, so as not
to discourage employers from creating new
retirement plans or cause employers to drop their
existing plans.

Unfortunately, 10-year scoring can have
major distortionary effects on policymaking for
retirement-savings incentives.
The reason is that 10-year scoring will show large
tax expenditures for traditional retirement
contributions but not for Roth contributions. Any

Who Wins and Who Loses?

People often note that Roth contributions and
traditional contributions are equivalent, as long as
tax rates in retirement are the same as they
are during a saver's working life, but this claim is
not quite right. The tax benefit on a traditional
IRA contribution is that it allows a worker to avoid

Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2017