Morningstar Magazine - August/September 2017 - 18
Dispatches
mix of account types in retirement. Because they
will have Roth and traditional accounts, they
will be able to pay their lower marginal tax rates
on traditional withdrawals, while using their
Roth withdrawals in place of traditional
withdrawals that would otherwise be taxed
at higher marginal rates.
Indeed, higher-earning workers with an employer
match and traditional retirement account
savings would benefit from the shift to Roths
under current tax rules, as their account mix would
result in lower taxes in retirement.
Roth Withdrawals, Social Security, and Sensitivity
to Inflation
One critical aspect of this analysis is the assumption
that current rules regarding Roth withdrawals
and their effect on Social Security benefits taxes
will remain unchanged. Currently, for a single
taxpayer collecting less than $25,000 in retirement,
Social Security benefits are not taxable. (For a
couple, the threshold is $32,000.) At higher levels
of retirement income, more of the benefit is
considered taxable income. For taxpayers earning
more than $34,000 in retirement, up to 85%
of the benefit can be taxable income ($44,000
for a couple).
Roth withdrawals do not count toward these
tests for the taxability of Social Security benefits,
somewhat offsetting the disadvantages
associated with them. However, these thresholds
are not indexed for inflation-unlike most
other parameters in the tax code. This creates an
increase in the percentage of Social Security
benefits that are taxed as withdrawals, and
the Social Security payments themselves increase
due to inflation. As a result, projecting the
effect of the shift to Roth is highly dependent
on inflation assumptions.
The higher inflation is (assuming real returns
remain constant), the less valuable the
Roth savings are as a mechanism to reduce taxes
vis-à-vis traditional defined-contribution savings.
For example, the 30-year-old in EX HIBIT 1 would
have 7.8% less income in retirement if she
had to use a Roth rather than a traditional definedcontribution plan. (We assume employer
18
Morningstar August/September 2017
contributions are traditional and inflation
is 2%, but the Social Security tax rules are not
indexed for inflation, as is current law.) If
inflation were 3.5% annually, her income in a Roth
system would be the same, but her income
with traditional contributions would fall, leaving
her just 5.9% worse off from a shift to Roth. (There
is a point at which her Social Security benefits
alone would be sufficient to incur a tax, but it will
take a very long time to get there.)
On the other hand, the value of the traditional
account is much higher if inflation is extremely low
for a sustained period.
Other Concerns: Behavioral and Practical
Although our analysis shows that a shift to
Roth could be harmful for purely rational
retirement savers, another concern is that workers
may not respond well to Roths. If workers
do not see an immediate tax benefit, they may
simply decide not to contribute.
On the other hand, it is also possible that workers
might decide to contribute at the same levels
they had before the shift because of the
"anchoring effect" of their existing contributions,
meaning they boost their aftertax income in
retirement and reduce their take-home income
today. In any case, a shift to Roth could be a major
behavioral experiment that could be a disincentive
for people saving for retirement.
Additionally, if workers do adjust their
contributions so the decrease in their take-home
pay after contributions is neutral, that could
mean they forgo their employer match.
For example, a worker in the 25% bracket (income
between $37,950 and $91,900 for a single
worker in 2017) who contributes 6% of his salary
to a retirement plan would see his paycheck
decrease by 4.5%, or less depending on state and
local income taxes. If he shifted to a Roth,
to see the same reduction he could only contribute
4.5% of his salary at most, but he would pay
no taxes in the future on the contribution. However,
if his employer matched his contributions
up to 6%, he would be losing his match,
or he would have to reduce his paycheck further
to maintain the match, which might not be
financially feasible.
Unintended Consequences
A stronger emphasis on Roth is a policy preference
driven by arcane scoring rules, and it might
lead to unintended consequences. Many workers
may end up with lower incomes in retirement from
a shift to Roth, particularly those with lower
savings today and lower employer contributions.
Further, we don't know the extent to which
people rely on the immediate tax benefits of
traditional contributions to save for retirement, nor
do we fully understand the possible behavioral
disincentives a shift to Roth could mean.
At a time when few are willing to make predictions
about policy, it seems likely that if Congress
pursues tax reform, 10-year budget scoring will
make Roth contributions too appealing to
ignore. Policymakers should carefully consider who
the likely winners and losers would be of such
a shift to Roth.
A more modest change, such as the one Camp
proposed in 2014, would affect fewer people. Still,
even in that case, any shift to Roth is an
intergenerational transfer, trading tax revenue
today for forgone revenue in the future. K
Aron Szapiro is director of policy research with Morningstar
Research Services.
Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2017
Contents
Morningstar Magazine - August/September 2017 - Cover1
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Morningstar Magazine - August/September 2017 - 1
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Morningstar Magazine - August/September 2017 - Contents
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