How tax reform could sting your retirement income

While 401(k) retirement savings plans are hardly perfect, they do serve an important purpose: making it easier for Americans to put money away for their later years.

But among the tax reform proposals currently being discussed is one that would convert part or all of workers' tax-deferred 401(k) contributions to Roth 401(k) contributions, which are made after taxes have been removed. That could significantly increase the federal income taxes that middle-income workers would pay throughout their lives. And it could reduce the amount of money they could spend throughout their lives after paying taxes.

A typical older middle-income worker could lose $500 per year if their 401(k) plan is Rothified (or should I say "Rothifried")? 

How the plans work today

Your contributions to traditional 401(k) plans are deducted from your taxable income for the year you make the contributions. You eventually pay income taxes on these contributions and accumulated investment earnings, but not until you withdraw them in retirement. 

Roth contributions are taxed the opposite way. You include them in taxable income for the year they're made, but you don't pay tax when on your contributions and accumulated earnings when you withdraw them in retirement.

The conventional argument for traditional 401(k) plans is that you'll likely be paying income taxes at a higher marginal tax rate while you're working compared to when you retire. This describes the situation for many older middle-income workers who are currently enjoying their peaking earning years and will most likely see a significant drop in taxable income when they retire.

On the other hand, if you expect to be in a higher income tax bracket when you retire, you might prefer making current contributions to a Roth 401(k) plan. This situation might describe younger workers who aren't yet enjoying their peak earning years and expect their tax bracket to increase in the years to come.

Many 401(k) plans offer both types of contributions and let the workers decide which best suits their needs.

Tax revenues could increase immediately and drop later

The Congressional Joint Committee on Taxation estimates that over the five-year period ending in 2020, 401(k) and other employer-sponsored savings plans will result in more than $580 billion in lost tax revenue to Uncle Sam. That makes these plans a tempting target for tax reformers, particularly because tax proposals are rated on their impact on the federal budget over the next 10 years.

Rothification of these plans would accelerate tax revenues during the next 10 years, but at the expense of tax revenues collected beyond 10 years.

Under this proposal, workers who currently contribute to traditional 401(k) plans would make Roth contributions that are immediately subject to income taxes, thereby increasing revenues to the federal government in the near future, all other things being equal. 

However, they would pay less taxes after the 10-year measurement period since their Roth contributions aren't subject to taxation when withdrawn in retirement. At that time, revenues to the federal government would decrease, all other things being equal.

Middle-income workers could pay higher taxes now

Many middle-income workers meet the classic rationale for traditional 401(k) plans, as you can see below from the first three federal income tax brackets that apply in 2017:

Tax Rate

Taxable Income

Single

Taxable Income

Married

10%

$0 - $9,325

$0 to $18,650

15%

$9,326 - $37,950

$18,651 - $75,900

25%

$37,951 - $91,900

$75,901 - $153,100

Many middle-income workers currently fall into the 15 percent or 25 percent marginal tax brackets. Workers who currently pay taxes at the 25 percent marginal rate will most likely drop to the 10 percent or 15 percent bracket in retirement. Workers who currently pay taxes at the 15 percent marginal rate would most likely drop to the 10 percent bracket in retirement, or they would not pay any income taxes at all.

Income taxes typically drop in retirement for three powerful reasons:

  • Most people will see a significant drop in total income when they retire, due to low levels of pension and savings benefits, and modest Social Security benefits.
  • Most middle-income retirees will have part or all their Social Security income exempt from federal income taxes.
  • People age 65 and older enjoy an increase in the standard income tax deduction.

An example

Here's a simplified example to illustrate these concepts. In this example, you lose $500 in spendable income based on one year's contribution with Rothification of your 401(k) plan, all other things being equal. If this result would be repeated for 10 years, you would have lost $5,000.

Suppose it's your last year working. You're currently in the 25 percent marginal tax bracket, but you drop to the 15 percent bracket during your first year in retirement.  You contribute to your savings plan in the current year, you retire in the next year and then withdraw your contributions. 

To keep things simple, let's assume you don't earn any investment income. Finally, let's suppose you have $5,000 in salary that you'd like to contribute to your savings plan in the current year and that your employer will match that amount.

If you contribute to a traditional 401(k) plan, all of the $5,000 would be contributed to the plan and you'd pay no income taxes on it for the current year. However, next year you'd withdraw the $5,000 and pay $750 in income taxes at that time (15 percent of $5,000), leaving $4,250 in aftertax, spendable income.

Now suppose that you can make only taxable Roth contributions to your savings plan. You still want to contribute the entire $5,000. All of it would be included in your federal income taxes in the current year, and you'd pay $1,250 at a 25 percent marginal rate.

As a result, your aftertax, spendable income for the current year would drop by $1,250, compared to contributing to the traditional 401(k) plan. However, in your first year of retirement, you could withdraw and spend the entire $5,000 contribution, an increase of $750, compared to contributing to a traditional 401(k) plan. 

The net result considering taxes paid in both years is that you've paid an extra $500 in income taxes with the Roth contributions, and your aftertax, spendable income for both years combined decreases by $500.

The result would be roughly the same if you complicated the example by considering investment earnings and the time value of money. The major factor in these results is the drop in your marginal tax rate in retirement.

Other considerations

In addition to these tax considerations, there can be other reasons to contribute to a Roth 401(k). Both traditional and Roth 401(k) accounts are subject to the IRS-required minimum distribution (RMD) at age 70-1/2, but Roth IRAs aren't. If you want to avoid the RMD, you could contribute to a Roth 401(k) account and then roll your Roth 401(k) account to a Roth IRA when you retire.

Another consideration is that your tax brackets might change under any tax reform package. For example, President Donald Trump's latest recommended tax package would have three tax rates: 10 percent, 25 percent, and 35 percent, and would double the standard exemption. 

However, the plan has no details on the thresholds for each bracket, which makes it difficult to make comparisons. Note, however, that in the above example, your current tax bracket would need to drop from 25 percent to 15 percent to neutralize the impact of Rothification.

Part of your retirement planning is to keep abreast of possible tax developments and how they might affect your bottom line. Ask your elected officials to be forthcoming about the details of any proposals, such as the tax brackets that would apply to new tax rates. Being an informed voter and writing to your elected representatives about your views can make a difference in the quality of your retired life.

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    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.