Many people, for a wide variety of reasons, are failing to save enough for retirement. The proposal presented and evaluated here seeks to expand retirement savings by replacing 401(k) plans with a modified Roth IRA.
The modified Roth IRA maintains key features of current Roth IRAs but adds additional sources of contributions in the form of employer matching funds and contributions for low-income households from the government. The modified Roth IRA creates incentives for young people and people with debt to start saving for retirement early in their career and prevents people from disbursing their entire retirement accounts prior to retirement. The tax incentives for contributions to the modified Roth could increase workforce participation. The introduction of the modified Roth is more equitable than the current system, which favors workers at firms with generous but expensive 401(k) plans.
Description of the modified Roth IRA:
- The basic rules governing worker contributions to the modified Roth are identical to rules governing current Roth IRAs. Contributions are fully taxed during the year the contribution is made. Contributions as with current Roth rules. Contributions cannot exceed wage income of the household. All employee contributions to the modified Roth IRAs can be withdrawn without tax or penalty at any time. All disbursements from the modified Roth after age 59 ½ are untaxed.
- The modified Roth allows for additional contributions from employers, from people hiring an independent contractor, and from the government. The rule allowing non-taxed compensation to independent contractors will allow more people to work independently and save for retirement. The government contributions are only available for workers from low-income households and will not exceed $10,000 over the lifetime of the workers.
- Disbursements from investment returns, government contributions and employer contributions would not be allowed until age 59 ½.
- The maximum allowable employee contribution to the modified Roth account is $10,000 per year, indexed for inflation.
Advantages of the modified Roth account:
- There are strong incentives for young people to open a Roth account and start saving as soon as they enter the workforce. The modified Roth account expands gains from saving at a young age because matching contributions would compound for years.
- People entering the workforce with student debt often delay or forego 401(k) contributions. There is less incentive to delay contributions to a Roth retirement account than a traditional one because contributions can be used for emergencies or for debt reduction without penalty or tax. The modified Roth maintains this advantage and allows for additional matching contributions, which will compound over time.
- Many young adults now routinely distribute a substantial portion of their 401(k) savings early in their career often when switching to a new position. The rules of the modified Roth IRA guarantee that a portion of retirement savings, employer and government contributions cannot be withdrawn until age 59 ½. This proposal substantially reduces shortfalls in retirement income caused by early distributions.
- Many employees work at firms that do not offer 401(k) plan or work at firms that do not match employee contributions. The modified Roth IRA will provide for some matching funds for workers
- Independent contractors do not have access to matching funds from people hiring them. The modified Roth allows for matching contributions for people hired as independent contractors. The matching contributions for contract employees would be the outcome of a negotiation between the firm and the independent contractor.
- Workers at firms without employer contributions could obtain matching contribution.
- Some current 401(k) plans lock workers into a high-fee 401(k) plan, which leads to a substantial loss in retirement wealth. The modified Roth account described here allows workers to choose a low-fee investment vehicle from a firm like Fidelity, Schwab, or Vanguard.
- Unlike the child tax credit, the government contributions to the modified Roth are only available for households with wage income. The combination of tax-free retirement savings and some matching contributions from employers or the government could induce some people to remain attached to the workforce.
- Some people will choose to report income they otherwise might have reported because without reported income they will be ineligible to contribute to the modified Roth an ineligible for matching contributions.
How to pay for the modified Roth IRA:
- The selection of the modified Roth leads to lower use of 401(k) plans and lower loss of tax revenue from decreased 401(k) usage.
- Additional tax revenue from the introduction of the modified Roth account could be obtained by reducing allowable contributions to 401(k) plans.
- A tax of 1 percent of Roth balance over $2,000,000 would recoup some revenues and would be more equitable than current required minimum distributions.
- The increased retirement savings induced by the modified Roth IRA could lead to a phased change in the Social Security retirement age from 62 to 63 to reduce the long-term Social Security deficit.
- Part of the cost the modified Roth could be offset by a reduction in the child tax credit. The combination of a modified Roth and a smaller child tax credit would remain favorable to low-income households and would expand labor force participation relative to current subsidies.
Many policy proposals either improve equity and reduce economic growth or worsen equity and increase growth. The additional subsidies created in the modified Roth proposal are both progressive and pro-growth. The new subsidies stimulate savings by low-income households, workers without access to the most generous 401(k) plans and new entrants to the workforce with high levels of debt and low levels of liquid assets for emergencies. The new subsidies, in sharp contrast to some existing subsidies like the child tax credit, stimulate workforce participation, which will lead to higher economic growth.