‘Rothification’ of DC Plans Could Harm Participants

Tax-reform may target the incentives to save in DC plans.

According to the Joint Committee on Taxation, defined contribution (DC) plans will have “cost” the federal government more than $580 billion in lost tax revenue by 2020.

This figure is a big reason why retirement plan providers and their plan sponsor clients are concerned about the potential “Rothification” of 401(k) plans. Legislation to this effect could mandate that some or all contributions to workplace retirement plans be made on an after-tax basis, with qualified withdrawals becoming tax-free.

While the concept can seem appealing to certain investors and improve outcomes in certain circumstances, some analysts believe that forcing the Roth approach on all savers will likely have negative consequences.  

“I’m hopeful that mandatory Roth is viewed as less and less attractive, because that’s likely going to have a significant effect on the incentives to save,” says Bradford Campbell, partner at Drinker Biddle and a former head of the Employee Benefits Security Administration (EBSA).

According to a preliminary survey by the Committee on Investment of Employee Benefit Assets (CIEBA), 78% of its members feel a switch to an all-Roth system would negatively affect participation rates in their 401(k) plans. Not one said the move would be positive on net, in fact. The biggest concern among members was participant communications, with 39% saying it would be very difficult or extremely difficult to speak about the value of workplace retirement savings in a Roth-only environment.  

“This would be uncharted territory,” explains Dennis Simmons, executive director at CIEBA. “You would have to reach out to millions of people, explain a complicated tax issue, and then ask if they still want to save.” He adds that participants confused by the Roth concept, and those who see more value in contributing on a pre-tax basis, may choose to reduce savings or stop saving all together. “This would be a huge shift potentially killing the traditional 401(k),” Simmons warns.

And while a 2016 Vanguard study of its recordkeeping platform indicated that enrollment in Roth 401(k)s has been steadily increasing in the last few years, the rate is still only 13%. This suggests most DC dollars are still flowing into plans on a pre-tax basis.

Stephen Utkus, head of the Vanguard Center for Investor Research, tells PLANSPONSOR that Roth-only DC plans could particularly hurt participants strapped for cash. “This could be a significant change for millions of people and the question we don’t have an answer to is what fraction of 401(k) contributors are short on cash every month, and will feel they need to make a change to their contribution rates because of the new taxes coming out.”

Campbell says Rothification may also unintentionally hurt small businesses.

“The tax rules have always been designed to tie the interests of the employer and the employee together,” explains Campbell. “So if you mess up the tax treatment and remove the incentive to offer a plan, small businesses aren’t going to go through the trouble, risk and expense of offering one at all.”

But like plenty of issues in Congress today, the future of retirement plans in the tax code is shrouded in uncertainty. One plan still being considered was first introduced in 2014 by Representative Dave Camp (R-Michigan), who formally served as chairman of the House Ways and Means Committee. He proposed for half of allowable retirement contributions to be taxed up front. If such a rule existed in 2017, that would mean the first $9,000 out of $18,000 allowable contributions to a 401(k) would be deferred on an after-tax basis.

According to a survey by the Plan Sponsor Council of America, nine out of 10 plan sponsors believe reducing or eliminating the tax incentives from 401(k) plans would lower savings rates overall.

Campbell says another key component to Camp’s plan is to freeze all contribution limits, which are indexed to inflation each year. Lawmakers will take a closer look at these and other proposals when they return from summer recess in September. The White House plans to have a tax-reform bill on the Senate floor by November, but this is far from a guarantee.

According to a study by Alight Solutions, about 75% of large employers offered a Roth 401(k) option in 2016, up from 50% in 2011 and just 11% in 2007.   

Director of research at Alight Solutions Rob Austin says that on average, people who contribute on a Roth basis save 9.7%, or two percentage points higher than the average savings rate overall.

Generally speaking, Austin tells PLANSPONSOR that average Roth 401(k) users tend to be “higher-wage earners but not totally affluent.” Sixteen percent of individuals contributing to a Roth 401(k) make between $60,000 and $79,000. The same rate applies for the $80,000 to $99,000 income group. But the rate falls to 13% for those making more than $100,000. It’s lowest at 10% among those earning $20,000 to $39,000.

Alight Solutions also found that only a very small group of workers decided to switch from a traditional to Roth 401(k) between 2015 and 2016. Their average savings rate in 2015 was 8.2%. Following the switch, that rose to 10.6% in 2016. Still, it’s important to note that these people chose to make the switch based on their own analysis and likely factored in tax rates into retirement savings decisions.

“I would conjecture that these people probably are more engaged with their retirement plans and took the time to consider the move,” says Austin.

Campbell adds, “I think the concept of Roth is very valuable to retirement planning, but there is a huge difference between having a voluntary Roth versus mandating that Roth be used predominately because Congress wants to raise revenue.”

In an all Roth-DC space, plan sponsors would have to amplify communications on the benefits of Roth to keep people enrolled at their current rate or increase contributions. The task becomes more pressing considering sweeping headlines about an American retirement crisis.

“A lot of things are still up in the air, but I think there is a unique role that the tax treatment of retirement plans plays and it’s ultimately about serving the best interests of American workers,” Campbell concludes. “Congress needs to remember that when they start thinking about how they’re changing the tax rules. This isn’t a question of how to raise the bottom line, it really is a question of what are the options going to be for real Americans when they’re facing their retirement. And are we helping them, or hurting them?”