How Tax Reform May Impact Your 401(k) Tax Benefits

How Tax Reform May Impact Your 401(k) Tax Benefits

Republicans in Congress are preparing to advocate for reduced tax rates. However, the challenge lies in funding those reductions. One potential option being considered: taxing your retirement savings upfront.

Many individuals in the retirement savings sector are concerned that legislators may decide to “Rothify” some or all of employees’ 401(k) contributions.

Currently, contributions to a traditional 401(k) aren’t taxed at the time they’re made. The funds grow without taxes until they’re withdrawn in retirement, when they are treated as regular income for tax purposes.

Conversely, Roth 401(k)s and Roth IRAs function differently. In a Roth account, contributions are made with after-tax dollars, allowing gains and withdrawals to be tax-free.

If lawmakers choose to “Rothify” 401(k)s, they could classify all or part of your future 401(k) contributions as taxable income in the year you make them.

Related: The deductions that may be eliminated by tax reform

This is not an entirely new concept. A similar idea was included in the 2014 tax reform proposal by Dave Camp, who was then the chairman of the House Ways and Means Committee.

Under Camp’s proposal, you could contribute pre-tax amounts up to 50% of the annual contribution limit, which is $18,000 this year. Any employer match would also be pre-tax, but any additional contributions you made would be immediately taxable.

Since the taxes due on long-term savings would be paid upfront, Rothifying 401(k)s could generate short-term revenue — Camp’s proposal was projected to raise almost $144 billion over ten years. This could help finance the permanent tax cuts that Republicans are seeking.

However, this change could lead to decreased revenue over time as the government would not benefit as much when employees retire and begin making tax-free withdrawals.

This timing change has been criticized as a fiscal gimmick by the Committee for a Responsible Federal Budget, stating “It produces savings in the near term by deferring costs to the long term.”

Related: How much can I expect to earn on my retirement savings?

So, would this be beneficial or detrimental for retirement savers? The answer is still uncertain.

“There is a lack of research on how workers and employers might respond,” remarked Nevin Adams, communications chief for the American Retirement Association, in a recent blog post.

This might change soon, as the Employee Benefit Research Institute is currently examining the potential impacts of Rothification on retirement outcomes.

Meanwhile, feedback from the industry indicates a strong opposition to Rothifying 401(k)s. The Plan Sponsor Council of America discovered that a majority of the 400 employer-sponsored plan providers they surveyed view it as a poor idea, advocating instead for maximum flexibility to design savings plans that align with workforce needs.

PSCA is also part of the newly established Save Our Savings Coalition, comprising plan providers, trade groups, and savings education nonprofits. Members of the coalition are concerned that Rothification might deter individuals from saving as much as they would under the current system.

Currently, many employers already provide a Roth option to their employees. For instance, at Empower Retirement, the second-largest plan provider in the U.S., nearly half of its 37,000 clients offer this option.

Overall, three-quarters of employer-sponsored plans include a Roth feature, according to PSCA. However, employee participation in these accounts remains relatively low.

“When given a choice, American workers tend to prefer traditional accounts over Roth accounts,” stated Jim McCrery, a former top Republican on the Ways and Means Committee and now head of the Save Our Savings Coalition. “Eliminating the availability of tax-deferred retirement savings solely to generate revenue would likely decrease savings, thus jeopardizing the financial security of future seniors.”

On the other hand, Camp estimated that his proposal would only impact around 17% of employees who contribute to 401(k)s, as most individuals do not contribute more than half of the permitted annual limit.

What is evident is that encouraging Americans to sufficiently save for retirement remains a significant challenge.

Correction: The original story referred to PSCA as the Profit Sharing Council of America. The organization has since changed its name to the Plan Sponsor Council of America.