Is Rothification Just an Accounting Gimmick?

Is Rothification Just an Accounting Gimmick?

The latest in buzzwords in the retirement industry is “Rothification,” or the conversion of all or part of defined contribution plans to Roth-like plans.

There’s talk of allowing plan participants to divide contributions between pre-tax and after-tax 401(k) plans, with the employer contribution continuing to be made pre-tax.  But is this a tax gimmick to boost short-term revenues for the government, or a real benefit to retirement investors? Whatever the case, there can be serious consequences.

There have been Roth 401(k)s since 2006, but they are less widely used. Many employers see the Roth option as a way to give plan participants tax diversification benefits. However, many avoid offering the option as they fear it may add confusion.

Average plan participants typically understand the concept of tax brackets and the implications of pre-tax versus after after-tax contributions and what will happen in terms of taxation when it comes time to make withdrawals.  But they may be less likely to have a full understanding of the concept of tax diversification and how owning both types of accounts can improve their income options in retirement.

Rothification may improve tax diversification, but experts are concerned that a shift to post-tax contributions could push down the savings rate and make many Americans less ready for retirement. Since savers have been inculcated with the benefits of pre-tax savings as the great selling point of the 401(k), many savers might view 401(k)s offering post-tax contributions as less attractive. Consequently, they could end up saving less.

Analyses comparing forecasted value of traditional and Roth accounts at retirement typically assume that savers contribute less to Roth plans. However, a  2015 study found no evidence that this is the case. John Beshears, assistant professor in the Negotiation, Organizations & Markets Unit at Harvard Business School and one of the authors of the study, noted that savers often follow two rules of thumb, “contribute to earn the full employee match and save some target percentage, say, 10 percent, of your income.”  Since savers are committed to these rules, their behavior is not likely to change under any scenario.

For more information, please read:
Gauging Rothification’s Impact | Wealth Management

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