The Roth 401k and the Man Behind the Curtain

The Roth 401k and the Man Behind the Curtain

I learned from a young age that rules are generally put in place for the collective good. Even though they may restrict certain individuals, they benefit others and the net sum of this help and hindrance is an overall positive. For example, when I was a little girl, my parents would serve us our dinner so we each got a bit of whatever was on the menu and we waited until everyone was served before we could dig in. Not only did we feel like a team when we broke bread together, but this method ensured that we all got a share of food. Without such rules, my big brother would have had the strength and alacrity to gobble up choice offerings in bulk, leaving very little for the youngest among us. So this rule seemed fair and we didn’t question it.

Likewise, our government establishes many rules with our collective good in mind. For instance, my youngest son got his driver’s license about a year ago and I was happy that the State of Connecticut, where we live, imposed a rule that he could not get his license before age 16. I took comfort knowing that he would have to go through hours of classwork about the rules of road and have to pass a road test before the state would allow him to drive without a parent in the car. He was also restricted from driving late at night. I felt that the state was on our side, concerned for safety of its citizens.

But what if we found out that tucked away in a piece of legislation was a provision that said if you could afford a luxury car, you wouldn’t have to pass a test to get a driver’s license? Mercedes and BMW drivers would face a far more permissive set of rules than other drivers. Would you start to lose faith in lawmakers? Would a cynical part of you conclude that the people who could afford luxury cars were the same people that had access to lawmakers, either through lobbyists or fundraisers? Because how else could you explain how this rule advanced the common good? You would likely feel the same sense of disillusionment that Dorothy experienced when Toto pulled back the curtain to reveal that the Wizard of Oz was merely a man and a fraud.

The Roth 401k is the luxury car of retirement plans and the Congressmen who passed this measure are the proverbial men behind the curtain. By way of background, in 1974 Congress enacted the Employee Retirement Income Security Act (ERISA) that regulates pensions and retirement plans and created the Individual Retirement Account (IRA). ERISA established a myriad of rules to incentivize people to save for retirement. The basic premise was that if you saved for retirement, this was good for society as a whole because you would be financially self-sufficient in your senior years. So when you contribute to a retirement plan today, you get a tax benefit either by deferring tax on the amount of your income you contribute or, through a feature called a Roth, named after Senator William Roth of Delaware in 1989. A Roth allows you to contribute to a retirement account with earnings that you had already paid income tax on and then these contributions can be invested and the earnings on these investments will never be taxed. You can even pass these Roth retirement accounts to your children and they won’t have to pay income tax on them either. Back in the eighties, Congress recognized that this Roth feature could be hugely beneficial financially, especially to the young with low earnings today who expected to be in a higher tax bracket tomorrow. But Congress recognized also that those in roughly the top five percent of our income distribution did not need this tax subsidy which was costly to the US Treasury. So they said that if your modified adjusted gross income were above a certain level ($133,000 as a single filer or $196,000 if Married Filing Jointly in 2017), you were not eligible to contribute. Even though some of the wealthy took advantage of a loophole in the tax code through a mechanism called the backdoor Roth IRA, in general we could still believe that those in Washington were working to create a retirement system that was fair and accessible to all.

But then in 2006, legislators authorized the birth of the Roth 401k under section 402A of the Internal Revenue Code. This provision allows employers to amend their 401k plan documents to allow employees to elect Roth IRA type tax treatment for a portion or all of their retirement plan contributions. This feature is open to all without regard to income limits. So now the wealthiest of Americans can contribute up to $18,000 per year ($24,000 if over age 50) into a Roth 401k and never, ever pay tax on the investment income this money generates.

Figure 1″ Dow Jones Industrial Average Since 1900: These Gains Would Go Untaxed if accumulated in a Roth

Such a giveaway to the top end of constituents makes Congress look as foolish as an exposed Wizard of Oz. It is obvious that they are working for high income earners who already have a penchant for savings.

Okay, you may be thinking. But what does any of this have to do with me? You may be living paycheck to paycheck or in a flexible employment situation which doesn’t offer you a Roth 401k option. This all sounds very theoretical. Yes, but here’s the point. We all operate under the assumption that one day we will retire if we haven’t already. And if the government is subsidizing the wealthiest of constituents, it is tipping the scales toward the most privileged, a regressive practice that is obscured by the fact that it’s complicated. Such policy does not create more retirement dollars for the general populace, it simply serves to distribute them to the top. And when Congress acts for the few at the expense of the many, it’s time to take our democracy back.

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