Republican tax writers on Capitol Hill are still considering changes to 401(k) retirement savings programs, downplaying President Donald Trump’s repeated pledges not to touch retirement account. A proposal to lower contribution caps to 401(k) plans, which are not taxed until money is withdrawn from them, could limit the amount Americans can save for retirement or force more Americans to contribute to their retirement by putting money into plans that are taxed immediately, such as a Roth 401(k) or Roth IRA. That cost the government $82.7 billion in lost revenue in the recent budget year ending Sept. 30, 2016.
The policy change would help pay for some of the tax cuts in the Republican plan — which is crucial to moving the bill through Congress. One of the considerations which have recently been made public called for a drastic reduction in 401(k) plan pre-tax contribution limits to $2,400, with the remaining amount of the contributions required to be in Roth (not tax-deductible). After news of a potential $2,400 cap emerged, the nonpartisan Employee Benefit Research Institute (“EBRI”) released some research on the potential impact such a threshold would have on savers. It found that of workers whose annual salaries are between $10,000 and $24,999, 38% currently contribute more than $2,400, according to EBRI, which drew on data from millions of administrative records from 401(k) record-keepers. That share falls to 32% for those earning between $25,000 and $49,999. But more than half of employees in thresholds above $50,000 would be affected, with an 87% share for those earning more than $100,000. Overall, the reduction in pre-tax 401(k) plan contributions would have a devastating impact on the way individual American’s save for retirement. However, there may be another way for Republicans to get the tax revenue they needed to help pay for their new tax plan – the two year stretch Roth conversion option. In 2010, pursuant to the Small Business Jobs Act of 2010 Roth Conversion Provision, Congress authorized any individual who converted a pre-tax IRA or 401(k) plan to Roth the ability to defer and spread income recognition from the conversion over tax years 2011 and 2012. A conversion in 2010 thus would reduce the marginal tax rate and total taxes due on what otherwise would be a larger single-year distribution. The 10% penalty tax otherwise imposed on early or excess distributions from an IRA does not apply. The two-year stretch Roth provision helped attract many taxpayers to the Roth conversion option in 2010 and helped generate significant tax revenues for Treasury to help fund individual and business tax incentives. According to the Senate Finance Committee Report, it was estimated that the 2010 two-year stretch Roth conversion and other Roth rollover provisions would generate offset revenue of $5.1 billion over ten years. While the two-year stretch Roth provision won’t come close to raising the eighty billion or so of loss revenue the 401(k) plan contribution limit is expected to raise, it will help bridge some of the lost revenue gap caused by the proposed tax plan.
Accordingly, Republicans may want to consider re-enacting a two year stretch Roth conversion option, which will raise significant revenues in the short-term to help pay for tax cuts, but would not impact the way Americans save for retirement via a pre-tax 401(k) plan or IRA, which have proven to be a successful approach to retirement savings. The difficulty is that politicians are seemingly focused on ways to raise short-term revenues to help pay for tax cuts without considering the long-term impact a reduction in pre-tax 401(k) plan contributions will have on the average American savings rate and overall long-term tax revenues. Proposals like this appear to generate new revenue, but that is partly because the government estimates tax revenue only for the coming 10 years – it does not account for income taxes collected on pre-tax retirement accounts into the future from taxable distributions, which would far surpass any tax savings from a reduction in pre-tax 401(k) plan contributions. In sum, adopting a two-year stretch Roth IRA conversion provision could help raise new tax revenues to pay for current tax cuts, without impacting how people save for retirement as well as limit the long term ability of Treasury, from a macro budgeting standpoint, to generate tax revenues from pre-tax retirement account distributions.