Tax Reform and the Possible Impact on Retirement

Michael Doshier: Okay Drew, here we are talking tax reform, what are the implications for retirement plans on tax reform?

Drew Carrington: So, Republican Congress has taken up the idea of pretty significant tax reform, certainly the largest changes in the tax code since either the Tax Reform Act of ‘86 or EGTRRA [Economic Growth Tax Relief Reconciliation Act of 2001]. The implications were that they were looking for ways to pay for tax cuts in other places, and one of the biggest tax expenditures, the way the tax code is calculated is the pre-tax savings in 401(k) plans. So people save in 401(k) plans, that money is not taxed—it’s taxed on the way out, many years in the future. And the way Congress accounts for things, it’s called the 10-year budget scoring window. So you think about: What is the impact on taxes in the next 10 years? So the problem with retirement plans is that the tax revenues occur far in the future, in many instances, well beyond the 10 years unless you change the nature of the contributions from pre-tax contributions to Roth contributions. So, this is named after a Senator, [William] Roth, and his idea was you pay taxes on the front [end] when the money goes in, the money grows tax-free, and then you do not owe taxes on when you take the money out in the future. So, from Congress’ perspective, more money in Roth [plans] increases tax revenues inside the scoring window. So, many of the proposals, much of what we will talk about over the next few minutes, have to do with—well, how can we pull that tax revenue inside that 10-year window?

Michael Doshier: So, are you saying that it’s not just merely a timing issue but because of rules of how Washington prices things, it actually looks like a gain in revenue, period, not just earlier versus later?

Drew Carrington: That’s right. You don’t change the amount of revenue. The individuals owe taxes on the money whether it’s on the front, in the form of Roth, or on the back when they take the money out as they are required to. With required minimum distributions [RMD], the RMD rules that kick in when you turn 70, people have to take the money out. When you take the money out you, pay taxes on it, at ordinary income tax rates, I’ll add there. This is really all about timing, and the way it’s accounted for. It’s not really substantive. Many of the other deductions in the tax code represent permanently forgone revenue for the Federal government. In the case of the retirement system, this is just—we are talking about timing.

Michael Doshier: You can pay me now or you can pay me later….

Drew Carrington: One of the two. One of the two. The retirement system as we see it today serves tens of millions of Americans and serves them well. We have made a number of changes to the retirement system, most notably in the Pension Protection Act of 2006—which introduced auto enrollment and default investment options or diversified investment options— those have made really important enhancements to the system. More people participating in plans, more people saving money, more people having diversified portfolios. So what we have today is a system that’s working well for many of those folks. In fact, the vast majority of Americans like the system as it is. So something on the order of 80% or more of Americans don’t want there to be changes in the tax treatment of their retirement contributions.¹ So, the system works. We are totally in favor of changes that are specifically designed to improve the system—to improve retirement readiness. If we want to talk about making changes to the system that will enhance retirement security—help more Americans get better prepared for retirement—we are a 100% on board with that. What we are not 100% on board with is making a fundamental change to the system for accounting reasons—not for reasons of enhancing retirement security.

Michael Doshier: So now let’s talk little more about the process right. Most people listening probably don’t have a real deep, detailed view of how Washington works and how legislation and regulation makes its way through, whether it’s a bill or in some other form of a law. Talk a little bit about where we are, and maybe a little bit more importantly where we have been recently because there are things that have been said in the news. What’s in, what’s out, where are we today?

Drew Carrington: For me, I would start with the “Schoolhouse Rock” [animated songs] and “I’m just a bill.” The process is, particularly for tax legislation, that the House passes a bill with changes to the tax code, the Senate then passes its own bill, they have to get together in a process called reconciliation, work out the differences. And then it goes back to the House and the Senate to be approved again, and then it goes to the president’s desk for signature. So that’s the process. Actually, on the very front of the process, we have committees, so in the House, Ways and Means, Senate, Senate Finance—each committee has to approve the text of the bill before it goes to the broader chamber.

In the House’s case, originally, the chair of Ways and Means, Representative Kevin Brady, had proposed really dramatic changes to the 401(k) system. In particular, he had proposed moving the pre-tax-contribution level from its current state of about $18,000 a year—to go up to $18,500 if the rules don’t change—all the way down to about $2,500. And then, anything above $2,500 would have to be Roth [after tax] contributions. So this is where the term “Rothification” came from. The idea is to move the majority of contributions into 401(k) plans in that design from pre-tax contributions to Roth contributions. So, mandated Roth contributions. This idea came up originally—Congressman Dave Camp had originally proposed it several years ago—although at a much higher threshold. His original proposal was at 50% of the max, so up to $9,000 pre-tax and then anything above $9,000 would be Roth. We are not 100% sure where the $2,500 figure came from. EBRI[Employee Benefit Research Institute] has run some analysis on this at different thresholds for mandatory Roth— it’s clear that, at the level of $2,500, you are impacting the majority of savers, the majority of participants and the vast majority of dollars that go into the system would be impacted, and this is even at very low salary levels. So, even people with salaries under $50,000 would still be impacted by those limits. That’s partly a function of the changes from the Pension Protection Act. We have more people participating, more people are automatically participating, and now we would be switching their contributions from pre-tax to Roth. That has a pretty material impact in folks’ take-home pay. We don’t know how people would react to that, which is why we are not in favor of Rothification. We don’t know how people would react. So, before we make a change like that, let’s make sure that the outcome is one that we are looking for, which is, again, enhancing retirement security.

Michael Doshier: So to recap that main first point: It’s not that the ability to contribute was being reduced. It was that the allocation of pre-tax dollars versus post tax dollars would fundamentally change.

Drew Carrington: That’s right. And obviously there were a lot of us who are concerned about how that might impact the willingness of companies to sponsor plans, the willingness of individuals to save, the willingness of individuals to save at the levels that they need to save in order to achieve retirement readiness. There is an industry group—Save Our Savings [SOS]—that came together, which Franklin Templeton is a part of, really designed to focus on that goal. Let’s enhance retirement security, let’s not make changes to the system for accounting reasons. Through the efforts of SOS and a lot of other folks, we managed to not have Rothification make it into the House bill. So what came out of the house committee—out of House Ways and Means—did not include Rothification in it at any level, so that was great news.

Michael Doshier: Sounds like a big win for now.

Drew Carrington: For now. That’s right.

Michael Doshier: What was the next thing that caught your eye that maybe had some concern in the original House bill?

Drew Carrington: That was the primary impact on the House bill—was the significant reduction on pre-tax contributions. We switched over to the Senate bill, the proposal in the Senate at that point, and the Senate actually introduced two different wrinkles. The Senate had actually proposed limiting catch-up contributions based on income. So, as the tax code is written today, you can save up to $18,000 a year pre-tax until age 50, and then at age 50, you can save an extra $6000 a year. That’s called catch-up contributions. By the way, there’s similar language in an IRA [Individual Retirement Account] for people who are saving outside of an employer-sponsored plan. What the Senate actually proposed—which was unexpected—in the original text of their bill, they proposed “means testing catch-up contributions.” So, the individuals making above $500,000 would not be allowed to make catch-up contributions. Now that was interesting for a couple of reasons. One is we are not really sure why you would want to limit savings. The Social Security System’s quite progressive. You actually really need folks who make more money to save more money, you want to incent that savings, and so, just means testing is problematic there. As a number of folks also pointed out, where does that one stop, right? Once you introduce means testing into the 401(k) system, we can see it show up anywhere, at any income level. Is it households or individuals, is it at much lower income levels…not just..

Michael Doshier: Younger ages?

Drew Carrington: Yeah, younger ages, not just with respect to catch-up, so a lot of concern there. That was actually taken out of the Senate bill before the committee voted on it. The Chairman, Senator [Orrin] Hatch, had made one proposed amendment in the Senate bill. The proposed amendment was to expand catch-up contributions from $6,000 to $9,000 but to require them all to be Roth. So, kind of a back door Rothification, if you will, which would only have affected people who are over 50 and are saving at the max, and then those contributions would require to be post-tax or Roth form as opposed to pre-tax.

The one thing that’s interesting about catch-up, you know—we talk a lot here at Franklin Templeton about participants who are over age 50, and that’s a group that is actually much more engaged than we typically think of. You are more likely to be able to use that age 50 milestone birthday as an opportunity to get people to save more, even people who aren’t saving at the max, so it was interesting to see the Senate propose making changes to catch-up contributions as opposed to affecting everyone in the system.

Michael Doshier: Now with your emphasis on propose, what do we know now with the Senate version?

Drew Carrington: So, the Senate version has now made it out of the committee, and so it remains to be voted on by the full Senate at this point, and what came out of committee didn’t include either one of those. So all of this talk about Rothification – in the end, so far nothing yet, has made into the final text. So, as it stands today, both the House Bill and the Senate Bill do not include changes to or require changes to the nature of either pre-tax or post-tax contributions to 401(k) plans, we are not done yet.

Michael Doshier: So what does that mean, if we see nothing in either version right House or Senate or at least most of the implications we were concerned about have disappeared, why still the focus on it?

Drew Carrington: So, in particular, in the case of the Senate, where they are going to try to get it passed under reconciliation, which means they don’t need the 60 votes. Again, go back to your Schoolhouse Rock [lesson], you remember that, the Senate has to have 60 votes to pass, except if you’re doing it under “reconciliation.” Kind of deep inside baseball here. This is where, the Senate, if it’s primarily a tax- or revenue-based piece of legislation, and it doesn’t increase the deficit beyond the 10-year budget scoring window, then you can pass it with 51 votes. So this is what the Republicans are hoping to do in the Senate. That not making the deficit bigger at the end of beyond the window is what has a lot of us still concerned. When you go back to reconciliation and go back to where House and Senate sit down together and say we have to make these two bills, which have lots of other things that are not necessarily retirement related, and may not line up one for one, and they have to negotiate that, and they have to find enough revenue both inside the scoring window to get it passed the House, and outside the scoring window to get it under reconciliation, that’s when we are worried that Rothification may show up again. It’s a way, again, under the accounting rules, to create tax revenue inside the scoring window. So it may show up again in reconciliation.

I think, you know, it’s worth noting that the feedback that both the House and Senate received on Rothification is overwhelmingly negative. Again, something between 80% and 90% of households, do not want to see changes to the tax treatment of their retirement savings.² That’s bipartisan. That’s a word that you don’t hear a lot these days. So, everybody recognizes this is politically risky to try and push through Rothification, even now.

Michael Doshier: To your point, 80% of households who have a retirement account say tax treatment is a big incentive to contribute and 90% of households oppose both taking away the tax advantages of retirement accounts and reducing the amount individuals can contribute to retirement account. So, a huge majority of numbers. What else is on your mind in this spot? What’s the goal here?

Drew Carrington: Well, ultimately we would like to see that we don’t end up with big material changes to the retirement system that are made, again, for accounting reasons not with the goal of improving the retirement system more broadly. There are a couple of things that are actually in both bills now that do enhance retirement security, so those are good, we are fans of that. There are a number of other discussions that continued to go on in the background—things that we might do to change the way retirement plans are regulated or overseen—that could enhance retirement security, and we want to stay focused on that too. So, within the bills today, as an example, there is a pretty arcane rule about— if you have a loan outstanding from your 401(k), and you leave your employer and typically go to another job, the loan is payable right away. So, usually within 60 days, and if you don’t repay it within 60 days, then it’s treated as a taxable distribution.

So, if you are under 59.5, not only do you have to pay income taxes on the proceeds of the loan, you have to pay a 10% penalty on it to boot. And, when people change jobs, or worse yet, if they have lost their job, that’s a particularly painful way to treat that. So, both bills include some language that make it easier for participants to continue repaying the loan at their old plan when they leave. So, it doesn’t become a taxable distribution, fewer folks are likely to get caught in that under that 10% penalty, and the money stays in the system, so that’s, that’s a plus.

Michael Doshier: You made reference to a couple of things. I know the other one—we often referred to retirement plans as 401(k)s which, for most of corporate America, that’s true, but you also hear these other numbers like 403(b)s and 457s, so is there something in that space as well?

Drew Carrington: So 457s are the defined-contribution plans for government employees, and then 403(b) plans are typically for not-for-profits, but, occasionally for some government employees, like school teachers, but it’s most often for universities or not-for-profit hospitals, so those are different. They look a lot like 401(k)s, but they are not identical. There’s a couple of things in the language here that make them more aligned, so that the treatment of contributions and withdrawals is more similar between the three types of plans than it is today.

The other point that I alluded to, though, not in the bills today but one that’s been kicked around for a number of years is this concept of multiple employer plans, what’s called a MEP [Multiple Employer Plan]. This is an opportunity where small employers could band together and offer 401(k) plans to their employees across multiple companies and then get the benefits to scale. And so, there’s been, again, bipartisan support for that kind of change and we may see that pop back in reconciliation as well. That’s another piece of language that’s been on the radar in Washington for a number of years.

Michael Doshier: With all the success we have seen in retirement plans over the last, really, 30 going on 40 years since 401(k)s came into existence—longer than that for 403(b)s—there’s still a fair amount of anxiety out there about being able to save effectively for retirement. I will quote some of our own stats from RISE [Franklin Templeton’s Retirement Income Strategies and Expectations Survey]. A majority of respondents, 53%, have expressed concern about not achieving their long-term retirement investment goals. Any thoughts about what we do from here?

Drew Carrington: I think the system has worked well, and it’s working better. There is a lot of discussion when we talk about 401(k) plans has been around since the early 80s, but really the modern 401(k) plan is about 10 or 11 years old. It dates back to the Pension Protection Act and the rise of behavioral finance. The changes that we have made, the nudges or the automation, those changes have increased participation rates, increased savings rates, improved diversification. That’s really only 10 or 12 years old. The impact of that is we are seeing the Millennials, as a matter of fact, have saved more at the same age than their prior generational cohorts, the Gen Xers and the Baby Boomers, had at the same age. Again that’s largely a function of automation, we get people into plans, get them started on the path, get them used to thinking about savings.

I think the other thing too is we have to be really careful about how we interpret some of the statistics about retirement readiness, particularly some of the more alarming statistics that are out there. We need to make sure that we stay focused on households. In many instances, people approaching retirement—retirement is a household decision, not an individual decision. You are always at some risk if you measure retirement readiness as what’s the balance in the plan you’re in right now compared to your salary, and is that enough, because for many Americans, particularly those working in the private sector, they change jobs pretty regularly, and that’s been the case for a long time. So, they likely have multiple accounts. So, measuring retirement readiness based on just the account that they are in now may not tell us everything we need to know, so maybe that’s the message that I would have for Washington which is… it’s important that we make changes to enhance the retirement system to improve retirement readiness, but let’s not make changes because we are alarmed by statistics which may not be telling the whole story.

Michael Doshier: As always Drew, a pleasure.

Drew Carrington: Thanks Mike.
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All financial decisions and investments involve risks, including possible loss of principal. The information contained herein is general and educational in nature and should not be considered or relied upon as legal, tax, or investment advice or recommendations, or as a substitute for legal or tax counsel. It is not intended to serve as the primary basis for your investment, tax or retirement planning purposes. Federal and state laws and regulations are complex and subject to change, which can materially impact your results. Always consult your own independent financial professional, attorney or tax advisor for advice regarding your specific goals and individual situation.

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The source for the references in this podcast of 80% and 90% of households not wanting to see changes to the tax treatment of their retirement savings is attributed to “American Views on Defined Contribution Plan Saving,” 2016, Investment Company Institute, page 7, 11.

The Franklin Templeton 2017 Retirement Income Strategies and Expectations (RISE) survey was conducted online among a sample of 2,013 adults comprising 1,009 men and 1,004 women 18 years of age or older. The survey was administered between January 5–18, 2017 by ORC International’s Online CARAVAN®, which is not affiliated with Franklin Templeton Investments. Data is weighted to gender, age, geographic region, education and race. The custom-designed weighting program assigns a weighting factor to the data based on current population statistics from the U.S. Census Bureau.
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¹ Source: American Views on Defined Contribution Plan Saving, 2016, Investment Company Institute, page 7, 11.

² Ibid.

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