A prominent Obama-era official has harsh words for “Rothification,” a budget move that U.S. lawmakers have talked about to raise new revenue.
“Rothification is a stupid idea that will not die,” said Seth Harris, former deputy U.S. secretary of labor and now a principal at Seth Harris Law Firm.
He spoke during an Insured Retirement Institute conference in Florida last month. Harris views Rothification as just another way for Congress to pay for a giant corporate tax cut, which he termed “a horrible idea.”
So what is Rothification and why should financial advisors care?
Rothification is the compulsory conversion of some of all traditional defined contribution plans to Roth-like 401(k) plans. It has been discussed in Congress as a way for the federal government to raise money in the near term to pay for its tax cut, says Amir El-Sibaie of the Tax Foundation.
Money set aside in a Roth IRAs is funded with after-tax income and withdrawn tax free when the time comes to take a distribution.
Traditional 401(k)s are funded with untaxed income and taxed upon withdrawal.
Rothification of defined contribution plans should be taken seriously, said Michael P. Kreps, a former senior pensions and employment counsel for the Senate Health, Education, Labor and Pensions Committee.
For now, Republican budget writers say it isn’t part of their 2018 budget or tax-cut plans.
Advisors Face Fewer Options
Where does Rothification leave retail financial advisors like Jason Lina of Resource Planning Group in Alpharetta, Ga.?
“It removes choices,” Lina said.
At present, 401(k)s function in the same way as a traditional IRA for tax purposes: Money set aside from a payroll deduction is only taxed when withdrawn.
Some employers offer Roth accounts within their defined contribution plans, giving employees a choice as to whether they want their 401(k) deductions to be taxed now or later.
If Congress were to convert all future 401(k) deferrals into Roth tax-structured accounts, employees setting funds aside through an employer-sponsored defined contribution would be taxed right away.
Losing the flexibility to be taxed now or later narrows investor choices, and at worst may discourage middle-class earners from saving for retirement, said Kevin Mayeux, CEO of the National Association of Insurance and Financial Advisors.
“Retirement savers need the flexibility and freedom to choose retirement plans that provide them with the greatest benefit,” Mayeux said.
“Forcing Roth products on all retirement savers could discourage many middle-income Americans from saving for retirement,” he said. “It would also be little more than a bookkeeping maneuver to increase the government’s near-term revenue at the expense of future revenue. It is not an effective means of paying for sustainable, permanent tax reform.”
Could Drive Away Business
Critics of Rothification have dismissed the move as a budget gimmick, and some financial advisors say they worry that it might even drive away business.
“It seems like a quick fix,” said financial advisor Robert Schmansky in Livonia, Mich. “It’s not something that’s sustainable.”
One of the reasons clients come to Schmansky is to seek help with tax questions.
Deferring taxes on retirement income until the withdrawal is a major part of the discussion as it involves a host of variables, overall family income, age, hardships, life events, Social Security, inheritance, future tax rates and tax brackets.
Retaining flexibility among retirement account options offers a critical lever available to advisors when it comes to sound financial and tax planning, Schmansky said. Financial profiles change every year and adjusting deferrals are part of that strategy, he said.
There’s no question that converting future employer-sponsored defined contributions into Roth tax structures would entail significant consequences for tax planners, he said.
“It removes another reason to work with a planner – that’s my biggest concern,” Schmansky said. “When the government proposes a tax it never goes away.”
No concrete plans for the Rothification of 401(k)s have been proposed yet, but it’s no secret that the GOP-controlled Congress is under pressure to deliver a tax cut, which means lawmakers want the money now, not 30 years from now.
How much money are we talking about?
Hundreds of Billions at Stake
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.
Tax deferrals on 401(k) and other qualified employer-sponsored plans will cost an estimated $958 billion between 2017 and 2026, according to a separate analysis by the White House Office of Management and Budget.
Not that the IRS wouldn’t eventually be getting those hundreds of billions of dollars in tax revenue, only that the IRS would be getting the money now under a Rothification scheme.
At the end of last year, 401(k) and 403(b) defined contribution plans had amassed nearly $5 trillion in assets, according to the Investment Company Institute.
InsuranceNewsNet Senior Writer Cyril Tuohy has covered the financial services industry for more than 15 years. Cyril may be reached at email@example.com.
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