Is Rothification Just a Budget Math Gimmick?

No. And for precisely that reason, it is likely to face stiff opposition

Trump administration officials and congressional Republican leaders are reportedly considering a proposal to “Rothify” retirement savings as part of a comprehensive tax reform package. The idea is that instead of excluding 401(k) contributions from taxable income in the year they’re made and then paying tax on withdrawals, individuals would pay tax on 401(k) contributions in the year they’re made and then be able to withdraw tax-free. The latter approach — already an option for individuals whose employers offer Roth 401(k) plans — would become mandatory with respect to some or all 401(k) savings. Similar changes on the IRA side would push individuals from traditional to Roth accounts.

The late Senator William Roth

As intro income tax students know, the difference between traditional and Roth plans shouldn’t matter for individuals whose marginal rates remain the same: both are equally attractive in present value terms. And the conventional wisdom holds that the difference shouldn’t matter for the Treasury either (assuming again constant rates). The choice between traditional and Roth plans affects the timing of tax collections but not the present value of tax collections. For this reason, the Republicans’ Rothification proposal has been characterized as a gimmick to make their tax package appear as though it loses less revenue than it does.

As an aside, it’s unclear why Republicans would find this gimmick attractive. Rothification brings tax collections forward in time, making it easier to hit a revenue-neutrality target in the near future and harder in the distant future. But the Byrd Rule, which governs the budget reconciliation process, allows for legislation that leads to a short-term deficit as long as there is no increase in the deficit outside the reconciliation window. Rothification would seem to be the opposite of what Republicans need in order to comply with Byrd: it makes it easier to achieve revenue neutrality within the window and harder to do so outside.

But the conventional wisdom regarding Rothification overlooks an important institutional wrinkle: management fees. Firms that manage 401(k) plan assets charge fees as a percentage of assets under management (AUM). That means that firms like BlackRock, Fidelity, and Vanguard should strictly prefer the traditional approach rather than Rothification because the traditional approach leads to more assets under management, and thus more fees.

To illustrate, imagine an individual facing a 40% tax rate who wants to save $60 (in after-tax terms) for retirement. (For all the underlying calculations, see here.) Assume that the rate of return is 6% and that fees of 100 basis points (1%) are assessed at the end of each year. Under the traditional approach, the individual invests $100 pre-tax today, receiving a deduction/exclusion worth $40 for an after-tax cost of $60. Over the next 20 years, that $100 grows to $262.31 (i.e., $100 x (1.06 x 0.99)²⁰). The individual can withdraw $262.31, pay a 40% tax, and wind up with $157.39 after taxes.

Under the Roth approach, the individual invests $60 after tax today, receiving no deduction or exclusion. Over the next 20 years, that $60 grows to $157.39 (i.e., $60 x (1.06 x 0.99)²⁰), which the individual can withdraw tax-free. Same result as under the traditional approach.

But from the perspective of BlackRock et al., these two approaches are very much not the same. Under the traditional approach, BlackRock charges 1% times $106 after year 1 and more each year after that. Total fees are $34.83 (nominal), or $58.40 in year 20 if BlackRock reinvests fees and earns a 6% return.

Under the Roth approach, BlackRock begins by charging fees of 1% of $63.60 rather than 1% of $106. Total fees over 20 years are $20.90 (nominal), or $35.04 in year 20 if BlackRock reinvests fees and earns a 6% return. (Not coincidentally, $35.04 is equal to 1 minus the tax rate times $58.40, or 60% x $58.40.) So the individual is equally well off under both approaches and BlackRock is worse off under Rothification.

If BlackRock is the loser from Rothification, who is the winner?

The answer is the Treasury. Under the traditional approach, Treasury collects $104.93 upon withdrawal in Year 20. Under Rothification, Treasury collects $40 in Year 1, which — if it reinvests at a 6% rate of return — yields $128.29 in Year 20 (i.e., $40 x (1.06)²⁰). That’s a heck of a lot better than the result for Treasury under the traditional approach.

None of this is to say that the conventional wisdom regarding the immediate deduction-yield exemption equivalence is wrong. What it does say is that the immediate deduction-yield exemption equivalence interacts with a particular institutional feature of the asset management landscape (fees assessed as a percentage of AUM) in a way that makes immediate deduction preferable from the managers’ perspective and makes yield exemption preferable from the Treasury’s perspective.

All of this suggests that there is indeed a policy justification for the Rothification approach being considered by Republican leaders, at least if we think that the assessment of fees as a percentage of AUM is an institutional feature with staying power. It also suggests, though, that there is a powerful constituency likely to resist the Rothification proposal: the asset management industry.

In sum, Rothification might be more — much more — than a budget math gimmick. And for precisely that reason, the prospects of passing Rothification look rather slim.