As the federal government seeks new ways to raise tax revenue this year, workers can expect renewed interest in the Rothification of their retirement accounts.
“Rothification” means steering retirement plan participants away from traditional, pretax 401(k)s and into Roth 401(k)s, funded with after-tax dollars. This would allow the federal government to collect more tax revenue upfront rather than waiting for retirees to pay when they take required minimum distributions.
According to Morningstar, some estimates put the value of those earlier tax revenues at around $1 trillion.
How Would Rothification Impact Retirees?
The idea behind the proposal is “pay me now or pay me later,” said Richard Craft, CEO of Wealth Advisory Group in Berwyn, Pennsylvania, in an email.
“For the short term, more tax revenue seems to be the focus, so Congress is advocating to collect the taxes now and deal with the loss of revenue down the road,” he said.
There is plenty of uncertainty about how Rothification, if implemented, would affect retirees. “We simply do not know the tax rates in the future, so we are taking a guess as to which works best,” Craft said.
Over time, a Roth plan can work better for many retirees. According to Craft, a bucket strategy might be a way to approach retirement saving. That would entail contributing to two buckets, one with pretax dollars and the other with after-tax. Each year, those allocations can be changed.
As with many aspects of retirement saving and taxation, your mileage may vary depending on your situation.
Rothification would reduce a retiree’s RMDs and taxable income, resulting in lower taxes in retirement, especially if tax rates rise in the future, said Nancy Gates, a financial wellness coach at Boldin in Mill Valley, California, in an email.
Rothification could prove disadvantageous for people currently in higher tax brackets who expect to face lower tax rates in retirement, she added.
“It would prevent these individuals from taking advantage of the tax deductions offered by pretax contributions, increasing their lifetime tax liability,” Gates said.
Potential Benefits to Retirees
Maximizing tax efficiency is a key tenet of long-term retirement planning, especially for younger investors.
“Because contributions to Roth IRAs are made with after-tax dollars, contributing to a Roth account early in your career allows you to avoid the higher tax rates that might apply in your peak earning years or in retirement,” Gates said.
That means people in the early stages of their careers who are in lower tax brackets would benefit most from mandatory Roth retirement accounts.
“The tax-free compounding of Roth IRAs also provides greater benefits to younger investors due to the longer time horizon they face,” she added.
[Related:7 Things to Know About Withdrawing Money From a Traditional IRA]
Why Might Congress Favor Rothification?
It’s well known that the U.S. has a budget deficit. While the attention is currently on cutting government spending as a solution, increasing revenue will likely be necessary.
According to data compiled by the Peter G. Peterson Foundation, which conducts nonpartisan research into U.S. fiscal challenges, Social Security, Medicare and Medicaid account for nearly 75% of mandatory spending.
“Spending on these federal entitlement programs is expected to continue to grow in coming decades,” Said Israelov, financial planner and wealth manager at Israelov Financial in San Francisco, said in an email.
“In the near future, Congress will be hard-pressed not to increase tax revenue, and Rothification is one of the major avenues they could use to temporarily plug the ever-increasing deficit gap,” he added.
Could Tax Changes Reduce Roth Advantages?
One reason financial advisors often urge Roth conversions is that it’s impossible to predict whether tax rates will go up in the future.
“Future tax changes could absolutely change the status of Roth account advantages,” Gates said.
The decision to save in a traditional versus a Roth account requires some guesswork about your future income and tax rates. “It requires taking action with the information and circumstances you have today but a flexible mindset for the future,” Gates said.
Choosing between a Roth or traditional account is a decision that affects not only the account owner but also their heirs. “There can be estate planning benefits to inheriting a Roth over a traditional account, but that depends on the income levels of the heir,” Gates said. “Future changes to estate or inheritance tax laws could reduce or eliminate any potential advantage for the heir.”
[Read: How to Manage an Inherited IRA.]
Alternatives to Balance Tax Incentives
Policymakers have alternative ways to encourage Roth savings without mandating Rothification.
For example, Congress could expand Roth contribution limits or allow for more tax diversification by increasing Roth conversion opportunities, said Chris Rivera, founder of the Ecommerce Accountants in Boca Raton, Florida, in an email.
“Taxpayers should be given more flexibility to choose Roth accounts proactively rather than being pushed into traditional tax-deferred plans,” Rivera said. “Encouraging more Roth savings ensures individuals build wealth in a way that isn’t vulnerable to future tax hikes, creating a more stable financial future.”
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What the Rothification of Retirement Accounts Means for You originally appeared on usnews.com
