Washington Beat

Will Tax Reform Hit Retirement Contributions?

Why a mandated shift to Roth-style plans would harm middle-class workers

by Aron Szapiro

Mr. Szapiro is director of policy research for Morningstar. He is responsible for developing research reports on policy matters, coordinating official responses to regulatory proposals, and providing investor-focused comments on policy issues to clients and the press. He also chairs Morningstar’s Public Policy Council. His research has been covered in The New York Times, The Wall Street Journal, The Washington Post, The Journal of Retirement, and on NPR.

The U.S. Congress and White House are talking seriously about passing a major tax-reform package. If they do, what can everyday 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.

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 investment retirement accounts (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 Congressional Budget Office (CBO), score this tax revenue, this future government revenue is mostly excluded.

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

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. That said, trying to make these predictions forces policymakers to consider the medium-term impact of their legislation, which is important.

Unfortunately, 10-year scoring can have major distortionary effects on policymaking for retirement-savings incentives, because they show large tax expenditures for traditional retirement contributions but not for Roth contributions. Any 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. Since 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.

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.

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 require even more future contributions to be Roth-designated.

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 paying his or her marginal tax rate on a retirement contribution—the highest rate a worker pays in our progressive tax code. The tax benefit on a Roth contribution may be as low as the otherwise effective rate—the weighted average of the taxes paid on all the tax brackets. It must be emphasized that the benefits of Roths can be on the otherwise effective rate, depending on the other retirement income a worker has and how he or she withdraws income for Roth accounts.

Unlike traditional contributions, Roth contributions reduce take-home pay by the full amount of the contribution, as the tax benefit on the Roth is deferred until withdrawal. In contrast, traditional contributions reduce a worker’s paycheck by much less, as the worker benefits from immediate tax savings for federal and, in most cases, state or local income tax.
To examine the tax-equivalent difference from a shift to Roth contributions, we assume workers will not reduce their take-home pay, but will adjust their traditional contributions according to their marginal federal tax rate as they shift to Roth. (Because they vary widely, we do not use state income taxes for this analysis.)

Our analysis shows that middle-class workers would likely experience the biggest income losses in retirement from a shift to Roth vehicles. For example, a middle-class, 30-year-old worker in the 25% bracket, earning $50,000 annually, could see a sharp 7.8% annual reduction in aftertax income in retirement from a shift to Roth contributions, assuming tax brackets remained the same (Exhibit 1). This example focuses on a younger worker because those are the ones for whom the change in tax timing means the largest changes in eventual income. Of course, younger workers who greatly increase their wages might benefit from the Roth, if they end up with more retirement income than they had at age 30.

Exhibit 1: Taking a Hit:
This middle-class worker would see a 7.8% annual reduction of retirement income if Roths replaced traditional, pretax contribution plans.

Single 30-Year-Old Worker Earning $50,000 Annually (25% Tax Bracket), Retiring at Age 65



Contribution Rate



Take-Home Pay Reduction

Same at 7.5%

Aftertax Replacement Income in Retirement (Including Social Security)



Percentage Change in Aftertax Income in Retirement from Roth Shift



Notes: Assumes a 3% real rate of return and a simple 4% drawdown rule applied across all accounts. These examples assume tax brackets remain the same at 2% inflation, but unindexed parts of the percentage of Social Security income that is taxable are not adjusted, as is current law. This analysis assumes no employer match or existing retirement savings, and a Social Security benefit of $19,200 in 2017 dollars and an inflation-adjusted standard deduction and personal exemption in retirement.

Higher-income and lower-income workers would be hurt less than middle-income workers under a shift to Roth contributions. As illustrated in Exhibit 2, higher-income workers have higher effective tax rates in retirement, increasing the value of Roth accounts in the drawdown phase. Lower-income workers are also hurt less because their tax burden is quite low during their working lives, reducing the benefits of traditional contributions. In fact, many low-income workers may benefit from a shift to Roth, because they may have no federal tax burden at all if they are eligible for the Earned Income Tax Credit or Child Tax Credit during their working lives.

The effects of a shift toward Roth contributions would be mitigated for workers with employer matches and for those who have already saved substantial traditional retirement savings account balances (Exhibit 2). Workers with employer matches or with account balances will benefit from their mix of account types in retirement. These workers 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.

Exhibit 2: Cushioning the Blow:
Savers who have access to employer matches and who have built nest eggs won’t lose as much or will gain in a switch to Roths from traditional plans.

Percentage Change in Aftertax Income From Shift to Roth Contributions for 30-Year-Old Worker

Annual Income at Age 30





Marginal Tax Rate (Bracket)





Annual Social Security Benefits





Baseline Case

(Using Assumptions in Exhibit 1)





3% Traditional Match





1x Salary Saved in Traditional Account





Notes: This analysis uses the same assumptions as Exhibit 1, with changes in income, match rate, and amount of savings in a traditional account.
*This person could also be eligible for a $250 Saver’s Credit, which is not factored into the analysis because it could not be received until after the annual year ended, reducing its effectiveness at helping workers save more.
**For this case, we use a blended rate of 27.4% because the earner straddles the 28% and 25% brackets.

Behavioral and Practical Concerns

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.

Unlike traditional contributions, Roth contributions reduce take-home pay by the full amount of the contribution, as the tax benefit on the Roth is deferred until withdrawal

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.

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. ◊



Morningstar, Inc. and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only/as opinions of the author and is not intended to provide, and should not be relied on for, tax, legal or accounting advice.