Rothification Could Chill Retirement Savings Landscape, Analyst Says

Converting employer-sponsored defined contribution (DC) retirement plans into Roth-like accounts could “dramatically change” the nation’s retirement landscape - and not for the better, an analyst said.

Many middle-class workers already are facing a lack of retirement savings. Those savings would drop still further if incentives to delay paying taxes - a major selling point of traditional 401(k)s and individual retirement accounts - are removed, according to Cerulli Associates.

“This incentive would no longer exist if tax reform succeeds in Rothifying the DC market and could dramatically change Americans’ retirement savings behavior,” said Jessica Sclafani, associate director at Cerulli.

At the end of 2015, the average 401(k) balance stood at $96,288, and the median balance was $26,405, according to Vanguard.

The average IRA account balance at the end of 2015 was $99,017 and the average IRA individual balance combining all accounts owned by the individual was $125,045, according to the Employee Benefits Research Institute.

Money Now vs. Money Later

Congress has talked about a Rothification scheme to fund tax cuts, although no concrete plans have been proposed.

A Roth strategy would allow Congress to raise money now instead of collecting the tax revenue decades from now.

In Roth accounts, named after former Delaware Sen. William V. Roth, investors don’t get a tax break on contributions, but earnings and withdrawals are generally tax free.

Roth investors pay tax “on the way in,” but avoid taxes when taking money “on the way out.”

By contrast, in traditional retirement accounts, taxes on the contributions are delayed until the money is withdrawn.

Tax deferrals from defined contribution plans could prevent the federal government from getting its hands on as much as $583.6 billion between 2016 and 2020, according to the Joint Committee on Taxation.

Critics have called Rothification “a stupid idea,” and some financial advisors say shifting the employer-sponsored defined contribution system to Roth accounts would limit choices of retirement investors from a tax-flexibility perspective.

In a recent survey, only 30 percent of 1,000 defined contribution plan participants were able to correctly identify the benefits of a Roth account, according to Cerulli.

Gambling with Behavioral Economics

Given the behavioral challenges associated with taxable contributions and the loss of immediate tax benefits, Rothification could cause some investors to trim or cease their contributions to employer-sponsored retirement savings, Cerulli said.

If investors are already confused about how Roth accounts work, there’s a higher chance they will not set aside anything at all. This is not unlike investors paralyzed by too many mutual fund options for their 401(k) accounts.

Recordkeepers and retirement benefits consultants, however, can prepare for Rothification and the threats it poses in terms of reducing defined contributions, Sclafani said.

Plan sponsors could implement the switch to Rothification on a “non-elective basis,” emphasize the importance of the company match, “and frame a tax break as a salary raise and an opportunity to increase retirement plan deferrals,” she said.

While these strategies may sound counterintuitive, they will help advisors and their clients “get in front of tax reform,” she said.

Contributions to defined contribution plans and IRAs combine for $1.1 trillion worth of total estimated income tax expenditures – tax code subsidies delivered through deductions and exclusions – for fiscal years 2016-2025, Cerulli said.

InsuranceNewsNet Senior Writer Cyril Tuohy has covered the financial services industry for more than 15 years. Cyril may be reached at cyril.tuohy@innfeedback.com.

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