Rothification is a term that is being tossed around a lot as tax reform takes center stage in Congress. What does Rothification mean? Proposals vary but, basically, it’s the idea of eliminating tax deductions and deferrals for retirement savings and instead mandating after-tax contributions with a payoff of tax-free earnings down the road. This is how Roth IRAs and Roth 401(k)s work so hence the term “Rothification” has emerged.
Is Rothification of our retirement system a good idea? It depends on who you talk to. Like so many other issues, Rothification is a polarizing one.
Proponents point to the great tax benefits that can be had with Roth accounts. The tradeoff for paying taxes now is a promise of completely tax-free withdrawals at retirement. A Roth retirement account can produce years of tax-free earnings. For the right individual, Roth accounts can be a great strategy and millions of Americans have made Roth contributions to both plans and IRAs and have converted their traditional IRAs to Roth IRAs, trading present tax bills for future tax-free withdrawals.
Another benefit to Rothification that supporters mention less but nevertheless is a motivating factor is that it works well for immediate budget needs. Because these accounts are after-tax they produce revenue in the present tax year as opposed to tax deductible and deferred retirement accounts which decrease tax revenue in the present. Of course, down the road, something politicians don’t like to dwell on, Roth accounts are revenue losers with the tax-free earnings they produce.
While Rothification has its supporters, it also has many opponents. Many experts have voiced concerns that Rothification would not be good for the retirement landscape. Americans are used to a retirement system that includes tax deductions for retirement contributions. An abrupt switch to a full Roth system would be a shock. Also, there are concerns that many simply would not make contributions without the incentive of an immediate tax break. Back in the eighties when universal deductibility was eliminated, IRA contributions became much less attractive to many taxpayers. Despite being around almost 20 years and offering big tax benefits, statistics show that Roth accounts are still the minority of retirement accounts. People like the immediate benefit of a tax break in the year a contribution is made. Opponents of Rothification argue that the last thing the retirement system needs right now is anything that would reduce contributions. Opponents also bring up the issue of fairness. It is right to do away with popular retirement savings options that benefit many Americans to fund tax cuts for others?
The future of Rothification is anything but clear. It may transform our retirement system or it may end up in the scrap heap of legislative proposals that never end up going anywhere. Stay tuned as the tax reform debate heats up in Congress in upcoming months.