TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Tuesday, September 5, 2017

Hemel: Is Rothification Just A Budget Math Gimmick?

Daniel Hemel (Chicago), Is Rothification Just a Budget Math Gimmick?:

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.

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. ...

[T]he 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. ...

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.

http://taxprof.typepad.com/taxprof_blog/2017/09/hemel-is-rothification-just-a-budget-math-gimmick.html

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Comments

The Roth and traditional IRA are not equivalent if the the investment earns a supranormal return that the market failed to anticipate when the investment was purchased, which means that Roth treatment is the worst form of consumption tax from a fairness perspective. As I say in my free e-textbook, "In Chapter 2, we saw that, under the E. Cary Brown yield-exemption phenomenon, denying deduction of the original investment but excluding returns (under a wage tax) will provide the same outcome as a cash-flow consumption tax (deducting the investment in the year of purchase but including 100% of the return, including basis recovery) only if the investment assets produce precisely the normal market return originally expected when the market set the asset price. If the investment produces a higher return than originally expected, that excess return is effectively taxed under a retail sales tax, VAT, or cash-flow consumption tax (when the extra, unforeseen return is spent on consumption) but is free from tax forever—even when spent on consumption—under a wage tax that reaches only labor income. For this reason, the Roth IRA ... can be criticized as being less fair than the traditional IRA, traditional § 401(k) plan, or qualified pension plan. When unexpected, outsized returns are obtained, more revenue is lost to the Treasury with the Roth IRA than with the traditional IRA and its equivalents (which means that tax rates on taxable wages must be higher than they otherwise would have to be to raise $X). Moreover, the more favored treatment of the taxpayer whose Roth IRA obtains that unexpected return is arbitrary when compared to those whose identical investment is taxed under the rules of the traditional IRA and its equivalents, thus violating horizontal equity. To appreciate this, review Brenda’s and George’s investments in Chapter 2. Both earned $100,000 in wages, both purchased investments expected to earn 5%, but George was taxed under a cash-flow consumption tax while Brenda was taxed under a wage tax. If their investments had both earned the expected 5% return, they both would have enjoyed the same $84,000 of after-tax consumption. Brenda’s investment, however, unexpectedly earned a 20% return, so she was able to enjoy $96,000 of after-tax consumption without paying any additional tax on that extra consumption. If George’s investment had also unexpectedly earned a 20% return, the extra return would have been taxed under his cash-flow consumption tax when spent on consumption." In short, extending Roth treatment is terrible policy. It should be repealed entirely. For more, see https://www.cali.org/books/us-federal-income-taxation-individuals, chapters 2 and 3.

Posted by: Deborah A. Geier | Sep 5, 2017 4:34:07 PM

Ah, screw it. Just go ahead and take it all. You know you want to.

Posted by: Dale Spradling | Sep 6, 2017 4:52:20 AM