To Roth or not to Roth: Taxing retirement plan contributions instead of payouts

Tax-deferred retirement savings plans include independent retirement accounts (IRAs) and employer-sponsored 401(k), 457, and 403(b) plans. These “save now, pay taxes later” plans mean a saver won’t pay income taxes on their contributions. Instead, they pay income taxes when they begin to take retirement account payouts. A person’s income while working usually is greater than when they’re retired, so the saver may pay less taxes over time. These plans are expensive to the government. The Joint Committee on Taxation estimates that defined contribution tax deferrals cost the U.S. Treasury more than $100 billion per year.

Because of the expense, some policymakers have proposed limiting the contribution amounts that can be tax deferred. Others have suggested changing to a “Rothification”[1] system where contributions are taxed, but payouts are not. MRDRC researchers Vanya Horneff, Raimond Maurer, and Olivia S. Mitchell examined whether “Rothification” would help close budget gaps and how such a change would affect Social Security claiming ages, work hours, consumption, and retirement savings. They were particularly interested in testing how Rothification might affect higher- versus lower-paid workers.

The researchers built a model that tracks individuals over their lifetimes and includes U.S. federal and state income taxes, Social Security and Medicaid premiums, Social Security benefit formulas, and real-world rules for tax-deferred accounts. They also included current low-interest rate (1%) and historical interest rates (3%).  “Specifically, we calibrate our model to data from the Employee Benefit Research Institute (2017) which reports 401(k) account balances for 7.3 million plan participants in five age groups (20 to 29, 30 to 39, 40 to 49, 50 to 59, and 60 to 69) in 2015.”

The authors find that taxing retirement plan contributions instead of payouts

  • leads to later retirement ages, especially for the better educated;
  • reduces lifetime work hours;
  • increases wealth and consumption inequality;
  • lowers lifetime tax payments by 6% to 10%.

Read the paper:

[1] Roth IRAs are named after Senator William Roth of Delaware who sponsored the legislation allowing them. Roth also regularly brought a St. Bernard dog with him while campaigning.

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