Republicans are ready to take on tax reform. And to make the numbers work, they may radically change the way your retirement savings are taxed.
Both the Trump administration and the congressional GOP want to slash tax rates for individuals and corporations. The problem is that that strategy will lose the government money, and any bill passed by reconciliation — a procedural move in the Senate that avoids the filibuster — must be deficit-neutral over the long term. Republicans want to pass tax reform via reconciliation so they can avoid negotiating with Democrats.
That's sent them scrambling to look for revenue replacements to offset dropping tax rates. "Options include capping the mortgage interest deduction for homeowners; scrapping people's ability to deduct state and local taxes; and eliminating businesses' ability to deduct interest," Politico reported.
But one idea is particularly eyebrow-raising: changing 401(k) savings accounts so that contributions are taxed up front. It's unclear if the change would apply to traditional IRAs as well, but it might.
As a way to close the revenue hole, the idea is really gimmicky. It could also upend the way Americans save.
Right now, you can sock money away in a 401(k) or a traditional IRA before paying taxes on it. The money goes into the account untaxed, then grows by earning interest over time. Once you retire and begin drawing money out of the 401(k) as income, then the IRS claims some of the money. In other words, 401(k)s and traditional IRAs are taxed on the back end.
A Roth IRA, on the other hand, is taxed on the front end. The money you put in is taxed along with all the other money you earn at the time. Then it goes into the account and starts growing. When you retire and start taking out the money as income, you can withdraw it tax-free.
Republicans are considering changing 401(k)s — and possibly traditional IRAs — to work like Roth IRAs. People who work in the tax, finance, and retirement industries call this idea "Rothification."
This wouldn't radically change the total amount of money coming into federal coffers — it would just look like it does, helping Republicans game the budget optics. All the plan would really do is take some of the money that the federal government would receive many years in the future, and deliver it now. Rather than change the bottom line, it would mainly just play with the budget windows that policymakers use to evaluate a law's effect on the deficit.
In fact, depending on how it's designed, the 401(k) proposal could even lose the government money, given that the pot of money taxed on the front end is smaller than the pot of money taxed on the back end.
And what about the people actually saving for retirement? The 401(k) is one of the cornerstones of Americans' saving habits. Completely altering the 401(k)'s tax structure would necessarily change the way Americans plan for the future.
On the one hand, getting taxed upfront reduces the amount of money you have left to sock away in a 401(k). On the other hand, the total pot of money being taxed would be smaller, so you'd be losing less to taxes in the aggregate. (Not surprisingly, many of the biggest critics of this idea are the industries that make money off 401(k) fees.)
It's hard to say whether or not this change would hurt savers on net, and there's very little research on the topic. It really depends on how individuals adjust their saving habits in response to the tax change, and it's very likely to vary from case to case.
In that context, what's arguably best for savers is options — and options are what Americans already have, between Roth IRAs and 401(k)s as they currently operate. Assuming the change would apply to traditional IRAs as well, the Republican proposal would take options away and force all Americans into the same saving strategy: getting taxed up front.
The details would also matter. A previous version of this proposal popped up in a 2014 plan by the then-chairman of the House Ways and Means Committee, Rep. Dave Camp (R-Mich.). Camp's idea would've split the difference by allowing Americans to contribute half of their annual 401(k) limit tax-free, while the second half would be taxed on the front end. Given how few people max out their annual allowable $18,000 401(k) contribution anyway, Camp estimated only 17 percent of Americans using 401(k)s would get hit with front-end taxes.
That last point highlights the much bigger absurdity here: The 401(k) may be a cornerstone of American retirement, but it's a very poor cornerstone. Thanks to decades of stagnant wage growth and poor job creation, most Americans just can't afford to save all that much for retirement to begin with. As a result, the 401(k) system mainly helps people who are already well-off; the top 20 percent of earners are 10 times as likely to have a retirement account as the bottom 20 percent, and they claim 70 percent of the attendant tax benefits. Wall Street also siphons plenty of money off the 401(k) system in the form of management fees, which makes retirees' portfolios even more rickety.
Republicans tend to dislike government retirement programs like Social Security, as well as the more generous defined-benefit pension programs that place most of the costs on employers and big business. Instead, they value the "individualism" and "personal responsibility" of private retirement plans like 401(k)s. But now that 401(k)s have displaced Social Security and pensions in importance as tools for saving, America faces a brewing retirement crisis.
You'd think, then, that Republicans would at least want to avoid messing with Americans' retirement any further. You might also assume they'd want to avoid the risk of making the system any more fragile.
Yet here they are, contemplating a big experiment on 401(k)s — and all to provide political cover for their tax-cutting schemes.