CHAPTER 10
OPPORTUNITY AND RISK: TAX REFORM 2017?
Be careful what you wish for.
As this book was heading to publication, developments in Washington, D.C., promised to have major impact—for good or ill—on America’s retirement savings system. For the first time since 1986, a sweeping reform of the entire U.S. tax code began to seem possible—this time with Republicans in charge of the House, the Senate, and the White House.
For those of us involved in retirement policy, the opening of this kind of rare “window” for comprehensive tax reform is both exhilarating and unnerving. It’s exciting because adopting more robust, better-designed tax incentives could go far toward actually “solving” America’s whole retirement savings challenge—once and for all.
But sweeping tax reform is also fraught with risks—largely because of Congress’s long-proven propensity to treat retirement savings incentives as a source of “pay-fors” for other tax cuts. Generally speaking, when politicians propose new tax cuts, they sift through existing tax deductions or deferrals to choose ones that they can reduce or eliminate so as to make other tax cuts revenue-neutral. Recent history, sadly, tells us that this search for “pay-fors” to offset individual and corporate tax reductions may again put retirement savings incentives at risk.
The fate of workplace savings plans is so deeply entwined with tax reform because of the central role that tax incentives play in spurring nearly all retirement savings. For any nation, its tax code embodies key economic and political priorities, effectively defining the “financial DNA” of entire economies. This is certainly true in the United States—whether we fully realize it or not. We offer generous tax breaks to spur retirement savings because we want to enable American workers to grow their wages into wealth for the benefit of their families, for their own retirement security, and for the nation’s economy as a whole.
As the chart in Figure 10.1 from Congress’s Joint Committee on Taxation (JCT) shows, achieving these goals is not cheap—especially given the deeply flawed way Congress “scores” the “costs” of savings incentives. Allowing both defined benefit and defined contribution plans to defer taxes on the funds flowing into them will, by current scoring rules, “cost” the government over $1 trillion in forgone revenue—or tax “expenditures”—over the half-decade from 2016 to 2020. Multiple other tax expenditures—are also embedded in the code—for employer-provided healthcare, home ownership, charitable giving, and capital gains from investment risk-taking.
FIGURE 10.1 Flawed budget estimates lump savings deferrals in with true tax expenditures
Source: Congressional Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2016-2020, January 2017.
I leave it to others to debate whether these various tax deductions are appropriate, fair, and effective. But I must insist that retirement savings incentives are categorically different from other once-and-gone “expenditures.” They are so different, in fact, that they should never have been lumped into this category to begin with. Unlike the other deductions on this chart, the taxes on retirement savings are not actually “forgiven.” They are simply postponed—then taxed as ordinary income when workers begin to draw on their DB pensions or DC savings plans for income in retirement.
Most Americans contributing to workplace savings plans today choose to contribute pretax dollars because the contributions reduce their tax bills in an immediate and obvious way. In a standard 401(k), IRA, or similar investment structure, those contributions are exempted from a given year’s income tax—and the savings can also grow tax free—but only until they are withdrawn. Again, those taxes are not forgiven—they are deferred. Unlike the once-and-gone tax breaks we grant for mortgage interest, employer-based healthcare, and other worthy causes, the taxes on most people’s retirement savings will be paid as ordinary income—often many decades later, when workers use their savings to pay their expenses in retirement.
Of course, many workers today can voluntarily make “after-tax” contributions by choosing a Roth 401(k) or Roth IRA—which allows them to look forward to tax-free withdrawals on retirement. But relatively few eligible workers—so far—have chosen these options even where Roth-style accounts are available on the job.
Pension economists have debated for years whether pretax or post-tax retirement savings contribution better suits workers and/or tax collectors. Some believe that paying taxes up front is more advantageous for workers. Younger workers, they argue, have lower incomes and hence lower income tax rates. So they don’t benefit very much from deductions because their effective income tax rates are usually less than 15 percent. Older workers, who may be paying 25 percent, 30 percent, or higher during their prime earning years, have far more to gain from pretax deductions. But they are also better positioned than young workers to afford higher savings. They are also old enough to appreciate the benefits of having tax-free “Roth” income once they do retire.
As to which option leaves more money with workers or with government, the only thing we can say is, “it depends.” How old are the workers who are investing, and how long will they remain in the workforce? What is their tax bracket while working and in retirement? Will they keep earning income through their retirement years? What is the prevailing interest rate and stock market performance across the years of investment? How did their investment portfolios perform? How fast or slow will they convert these investments to cash?
The challenge of this calculation is wildly complex. But human nature is fairly clear on one point. Faced with a choice between taking the immediate gratification of a tax break this year—versus paying those taxes and then contributing to a lifelong tax-free “Roth” account—fully 92 percent of workers take the immediate gratification of the current tax exemption. They simply don’t worry about having to pay taxes on their savings decades later. The 8 percent of workers who voluntarily choose Roth options today may be taking the most beneficial financial path (again, it depends on their individual situation). But a split of 92 percent versus 8 percent in this binary choice suggests that the market has spoken clearly (as it so often does) regarding investor preference.
Tax Reform and Retirement Savings
Which brings us back to tax reform. While a broad tax reform would bring with it dozens, even hundreds of adjustments across our economy, when it comes to retirement, options for reform are few. These options are largely shaped, and, I would argue, distorted, by the way that Congress “scores” the cost to Treasury of offering any kind of retirement savings incentive.
Current scoring methodology, created by the Budget Act of 1974, requires congressional budget makers to “look out” 10 years—and no more—to calculate the cost to the Treasury of granting tax exemptions to retirement savers. So any increase in savings deferrals, whether caused by higher savings rates or more workers taking part in plans, will inevitably score as very costly over the first decade—even though those savings will be taxed, many years later, when savers draw them down to spend. By definition, this accounting convention is blind to the long term. But retirement assets rise, appreciate, and draw down over a half century or more.
Broadly speaking, there are three points in time or phases when taxation or tax exemption can impact retirement savings. Current income taxes can be imposed or exempted on wages saved in any given year—making them “pretax” or “after-tax” contributions. Taxes can also be either imposed or exempted on the interest, dividends, and capital gains earned in retirement accounts over the decades while these assets grow. Lastly, taxes can be levied or forgiven on funds that retirees draw from their accounts.
The earlier any worker contributes, the more time he or she will have to benefit from the miracle of compounding. Indeed, the sum of assets being taxed in withdrawal—after decades of compounding tax free—will most often be far greater than the worker’s own lifetime of contributions. This makes long-term tax-free appreciation the most powerful benefit of either traditional pretax or Roth-style after-tax savings models.
For those of us in the retirement savings industry, it is frustrating to see politicians and interest groups pushing and pulling at our workplace retirement savings system in the context of tax reform. If we are to ever build the fully fleshed-out retirement system we’ve called Workplace Savings 4.0—to benefit virtually all workers—we need to clearly understand that our workplace savings incentives are “deferrals,” not “expenditures.” And we should all also know that the 10-year budgetary “window” that Congress uses to measure the “costs” of tax breaks for savings overstates their true cost by as much as 50 percent. All of us will pay taxes on our pretax DC savings once we draw them down.
It’s true that any tax system that is fundamentally overhauled only once every 30 years is bound to have accumulated decades of unwarranted exemptions, narrow-cast tax breaks for industries, and a host of special-interest tweaks that build up like dead, dry tinder in an overgrown forest. We do need to clean the underbrush periodically—or risk fiscal forest fires down the road.
But as we aim for a tax code that (we hope) is more rational and transparent, the first principle for reform should be “Do no harm.” The worst outcome of a poorly done tax reform would be to inadvertently lower Americans’ already-too-low savings rates. Getting retirement tax policy right is not just about helping workers secure future incomes in retirement. It is the key to sustaining and building on America’s comparative advantage over those nations that still have no well-funded base of mass investing for their working people.
The Broken Compass of Congressional “Scoring”
I have argued for years that Congress’s use of a 10-year “window” to estimate the budget costs of retirement savings is not just dead wrong, but damaging—on multiple levels. It systematically overstates the “costs” of deferrals that flow back to the Treasury long after that 10-year “window” is closed. And it takes no account—zero, nada—of the huge benefits that these savings deliver to the government by reducing future dependency and fueling faster economic growth. It tempts policy makers to falsely pit national solvency against the personal solvency of American families. By doing so, it provides a perversely negative guide to policy choices. Virtually every serious policy maker in Congress agrees with me.
Yet changing budgetary “scoring” methodology that dates back to the 1970s seems as difficult as passing a major new act of legislation. We are likely, then, to go into our next major tax overhaul navigating by this broken compass. Sheer force of habit, inertia, and the debilitating spirit of “We’ve always done it this way” are just too strong.
Little wonder, then, that in early 2017, as talk of major tax reform heated up, new proposals emerged in some retirement policy circles in Washington to simply “step over” this scoring debate, perhaps even play a kind of jujitsu with the Budget Act’s 10-year “window,” by adopting either a hybrid of pretax traditional and post-tax Roth incentives—as Chairman Camp did—or by shifting fully to an “all-Roth” system.
By some estimates, going “full-Roth”—eliminating all pretax deferrals for future retirement savings—would “score” as much as $600 billion in 10-year “savings” for the Treasury. One variant of this proposal suggests that we could plough back $200 billion to $300 billion of these notional savings to pay for tax credits for retirement savers and also offer strong new financial incentives for companies that establish workplace plans. In theory, that could more than compensate individuals for lost deferrals and significantly increase overall coverage as more firms set plans up.
But there are more than a few risks. The first—and most serious—is that congressional tax reformers might simply “pocket” the alleged savings from switching to an “all-Roth” model, use that money only to reduce future deficits, and give no tax credits at all to savers who’ve lost their deferrals. Going “all-Roth” that way—without some very generous tax credits to make up for lost deferrals—would almost surely have a sharply negative impact on savings behavior. The shock might cause millions to cut back or even stop contributing to their plans.
Behavioral finance is clear that simplicity and automaticity work. And workers today have demonstrated their preference for traditional IRAs over Roth accounts because of their simplicity. Deductions are clearly expressed and calculated annually. Very few workers who could do so today actually choose a blend of traditional and Roth savings. But such a hybrid model may well be what emerges from this year’s tax debates.
As I mentioned, many Washington tax experts expect the never-enacted “Camp Draft” of 2014 to serve as a guide for the next generation of tax reforms. The Camp proposal would have set corporate income tax rates at 25 percent and created tax brackets of 25 percent and 35 percent for nearly all workers. It would have repealed the unloved and outdated Alternative Minimum Tax and opted for a cross-border territorial tax system that has long been advocated by business leaders and economists.
To partially pay for these changes, Camp proposed a kind of “half-Rothification.” His bill would have allowed retirement savers to still contribute some money to a traditional IRA and get a deferral. But beyond a specified limit, any further contributions would have to be after-tax money and go into Roth accounts.
The Camp draft was a down-the-middle kind of tax reform. Its carefully crafted compromises sought to give and take something from all stakeholders—taxpayers and tax collectors alike. It sought revenue neutrality (more or less, given that no one can predict the future) and aimed at “distributional neutrality”—meaning that changes would not weigh too heavily on any single income cohort.
If Congress opts for a “Camp 2.0” approach, we will have much to debate in terms of the fiscal implications of this plan for the government and the savings implications for American families. But from the perspective of a finance practitioner, a modified “Camp” approach might very well increase the complexity of retirement savings and take us in precisely the wrong direction.
Any proposal that mandates a blend of traditional and Roth options would require workplace savers to annually revisit their investment mix. What proportion of savings should be deployed to traditional accounts and what proportion to Roth? And how should this calculation change over time, factoring in new circumstances and liabilities?
With no clear actuarial signals as to the long-term benefit of either savings format (each worker would be uniquely impacted), workers would find themselves where they were decades ago, before automatic enrollment and automatic allocation, when they were forced to choose from among dozens of investment allocations and hope for the best.
Given that most Americans today choose traditional pretax savings deferrals, might a mandatory conversion to Roth result in reduced levels of savings? That’s a tough question—with no clear answers.
Many analysts presume that those who wish to save will save and that the impact of introducing more Roth options will be negligible. Academic studies of savers’ behavior in plans that have added Roth options to more traditional tax-deferred savings plans find little change—up or down.
We do know that a partial or complete conversion to Roth would have different impacts on different kinds of savers. And if this overhaul were to happen without a generous package of countervailing tax credits, then younger and lower-income workers might well be discouraged once they noticed their cost of setting aside savings rising paycheck to paycheck.
The departure of lower-income workers could negatively affect employers, too, by shifting their workplace plans toward noncompliance with “nondiscrimination” rules mandated by the Employee Retirement Income Security Act (ERISA). These rules aim to ensure that workers at all income levels take part in workplace plans so that their benefits are not concentrated solely among highly compensated employees and executives.
With so many variables in play, it is exceedingly difficult to forecast what a shift to an “all-Roth” structure would do to Americans’ savings behavior. But we do know that complexity breeds uncertainty, leading too often to glorified guesswork. Introducing new complexity, forcing workers to guesstimate the impact of these choices over the course of decades of work, taxes, and retirement, would create new minefields of error and risk. Behavioral experts are quite clear on how workers respond to opaque risk; they shut down. So increasing complexity in our retirement savings could simply lead to reduced savings across the board.
If Congress were to decide on a mandatory shift away from traditional savings deferral, then the “simplicity doctrine” would suggest that rather than adopting a complex “hybrid” system we simply bite the bullet and make a once-and-done, permanent shift to the all-Roth model.
Such a clean break to an all-Roth model for future savings (while “grandfathering” existing investments) would be a shock, at least initially. But it would also be simpler in terms of accounting, employee education, investment strategies, and income projection. It might even help close our huge “coverage gap” and bring millions more workers into savings plans—provided this major change included generous tax credits to companies that set up plans and to individual savers who would be losing their familiar tax deferrals.
In the spirit of colonial New England, then, let me suggest one principle that should guide this type of retirement tax reform: “No Rothification without tax-creditization!”
Now, I don’t think we’ll ever see a crowd of demonstrators carrying that sign. But I’d support them if I did. Because I believe that any consideration of shifting to an all-Roth model for retirement savings won’t work well unless it includes a full array of new—and permanent—savings incentives to ease the transition:
- Robust tax credits for small employers to establish new plans with auto-enrollment and a specified minimum deferral
- Simplification of retirement plan regulations to facilitate employer participation and to make it easier for workers to do the right thing
- Expansion of the Savers Credit to attract lower-income employees into plans, together with expanded eligibility that would make it available to fully half of all taxpayers
- Expansion of contribution limits by up to one-third so that senior managers and small business owners could increase their overall deferrals
- Creation of a Universal Roth IRA for short-term and long-term family needs and a Starter 401(k), with streamlined regulation, for small businesses
- Creation of a Children’s Savings Account to pay for education and to help young adults with financial flexibility after college
- Adjustment or elimination of the required minimum distribution rules (RMDs) so that workers can stay in the workforce while also protecting their accumulated assets
- Establishment of Multiple Employer Plans (MEPs) through which unaffiliated small businesses could create pooled 401(k) plans that take advantage of economies of scale and their aggregated pricing power
“Rothification” of the American workplace retirement system would be a major change. But it need not be traumatic if the loss of deferrals is fully compensated by strong financial incentives for individual workers to save and for companies to offer savings plans. Taken together, the tax incentives mentioned above might generate as much as $1 trillion in new retirement savings over a decade and increase middle-class family retirement income substantially. Such a reform could also focus most tax credits on workers making less than $100,000 per year—thereby making the whole system more equitable. But “Rothifying” our savings system without such offsets could be very damaging.
That’s why my message to retirement policy makers is simple: don’t hurry, don’t presume. Keep your eye on the prize of higher overall savings rates. Proceed with caution. When it comes to impacting retirement savings, tax reform needs a scalpel, not a meat cleaver. An awful lot is at stake—and at risk.
Remember that our existing laws have fostered a multitrillion-dollar pool of retirement savings, owned by tens of millions of workers and channeled through the world’s richest capital markets. Build on that. Tax reformers should aim to realize our workplace savings system’s full potential—by raising workers’ saving rates, offering plans to all, and bringing millions more workers aboard the savings train.
By contrast, any new legislation that inadvertently reduces savings could erode the vast flows of patient capital that American workers channel into our capital markets with every paycheck. These savings drive economic growth, which in turn generates higher future tax receipts that can bring down government deficits over the long run. Strong, sustainable economic growth is by far the least painful, and the most American, way to meet our long-term fiscal challenges.
Our workplace savings plans are proven engines of such growth.
As this book goes to print, no one knows whether Congress will actually be able to enact a comprehensive reform of the tax code—or how that may affect retirement savings. But even as Congress wrestles with that challenge, I urge our leaders in Washington to focus on the larger, long-term questions at stake:
- Do the proposed changes help or hurt Americans’ ability to save for our future?
- Does any given change free up “scorable” resources that can be used to increase contributions, expand coverage, and foster the creation of new savings plans?
- Will the changes expand the overall market for retirement savings by increasing flows into retirement accounts and bringing more workers into the system?
- How much additional revenue might the government generate, and how much additional savings might workers accumulate down the road—not just in the 10-year budgetary scoring “window”, but over half a century or more?
Our retirement finance mission is measured in generations. The tax code meant to advance this mission should be fair, transparent, and supportive of American workers for generations into the future.
Let our leaders hear from you that Americans’ savings are not playthings for politicians to manipulate. These assets are the American people’s hard-earned wealth, the seed corn of our economy’s future. All of us—from Wall Street to Main Street, from mom and pop to the U.S. Congress and Treasury, should be pulling in the same direction—to help more Americans benefit from a retirement savings system that has achieved so much, and can still become so much better.
We really are all in this together.