Research

Workers See Regular, Roth 401ks as Same

Due to differing tax treatments, each $1,000 placed into a traditional, tax-deductible 401(k) costs less today than $1,000 placed into a Roth 401(k), but that Roth will provide more money in retirement.

New research indicates that workers don’t recognize this difference between the two types of employer-sponsored retirement accounts when deciding how much to save.

A $1,000 contribution to a traditional 401(k) costs the worker less than $1,000 in take-home pay, because the income tax hit on the $1,000 will be delayed until the money is withdrawn from the account. But a $1,000 contribution to a Roth 401(k) costs exactly $1,000 in take-home pay, because the worker has to pay income taxes on it up front. The Roth funds, including the investment returns, will not be taxed when they’re withdrawn.

A Roth 401(k) might be thought of as shifting additional money into the future, allowing people to spend and consume more in retirement. (This assumes the same tax rate over a worker’s lifetime.)

The upshot: to get a set amount of after-tax money for retirement, workers could contribute less to a Roth than to a traditional 401(k). But that’s not what they do.

According to a study tracking contributions by thousands of employees at 11 large companies that added a Roth 401(k) option after 2006, there was no significant change in total contribution rates between employees hired in the year prior to the Roth’s introduction and those hired immediately afterward.

A separate survey by the same researchers also indicated that people don’t understand the different tax consequences of these two types of accounts. Survey respondents were asked how much an imaginary couple earning $100,000 should contribute to a retirement plan at work.  One-quarter of the respondents were asked to choose a contribution for a traditional 401(k), one-quarter for a Roth, and half chose contributions for both types of accounts together.

All three groups arrived at roughly the same contribution rate: 11 percent of the couple’s earnings. Nearly half of the respondents, when asked two questions about the tax rules governing Roths and traditional 401(k)s, also got both questions wrong.

This study confirms that the tax implications of workers’ decisions often elude them. When deciding how much to contribute, they seem to rely on simple rules of thumb or arbitrary benchmarks like the contribution rate required to get their employer’s match.

The research reported herein was performed pursuant to a grant from the U.S. Social Security Administration (SSA) funded as part of the Retirement Research Consortium. The opinions and conclusions expressed are solely those of the author(s) and do not represent the opinions or policy of SSA or any agency of the federal government. Neither the United States Government nor any agency thereof, nor any of their employees, makes any warranty, express or implied, or assumes any legal liability or responsibility for the accuracy, completeness, or usefulness of the contents of this report. Reference herein to any specific commercial product, process or service by trade name, trademark, manufacturer, or otherwise does not necessarily constitute or imply endorsement, recommendation or favoring by the United States Government or any agency thereof.

8 Responses to Workers See Regular, Roth 401ks as Same

  1. It would be good to provide a couple of hypothetical examples of equal amounts of money put into each, how much one might expect to earn under hypothetical investment circumstances and how much would be available to withdraw in the future with the tax consequences.

  2. Mark Zoril says:

    I agree with this completely! I enroll middle class people all the time in retirement plans that have both pre-tax and after-tax Roth options. Many of them are on a budget and do not fully understand the differences between the two. In addition, most people have a pre-determined amount they want to save, whether it is 3%, or 7%, or 10%. As we discuss the pros and cons of each approach and how it will impact their net pay, they rarely change the amount they save based upon whether or not it is pre-tax or after-tax, even though they can save more pre-tax.

    When most people determine the amount they can save, whatever it is, they normally stick with that number. And they do this even though they know they can easily change at anytime.

  3. Kevin Donahue says:

    Contributing to a Roth within your employer program limits investment options. Contributing outside the employer plan provides more flexibility.

    Also, look at any study of employee income growth and the steady 11% looks good.

  4. PJ says:

    I have both an IRA that will have devastating tax implications when I “age out” and a Roth that I pay taxes on every April as I put in the maximum. No surprises for the Roth.

    Would like to think the Roth will eventually be the better bet, but would like some hypothetical examples of each. No doubt the earlier contribution to the Roth has better opportunities to make up the difference, but maybe I am expecting too much.

  5. Ramona Winkelbauer says:

    I’m happy the respondents *wanted* to save 11%! My employer has a match of 5%; many employees aren’t even contributing up to the match.

    One other caveat about the survey: with all of the changes to tax law that Congress makes, it seems completely rational behaviour to desire a tax break now over a possible one later…

  6. Contributing to a Roth within your employer program limits investment options. Contributing outside the employer plan provides more flexibility.

  7. Andy Simms says:

    I just read the article referenced above via the BPP401k Newsletter. I completely see the point of the piece but I think the bias toward Roth contributions isn’t necessarily supported by the facts. For instance, this line is misleading, in my opinion:

    “A Roth 401(k) might be thought of as shifting additional money into the future, allowing people to spend and consume more in retirement. (This assumes the same tax rate over a worker’s lifetime.)”

    The decision to contribute to a traditional account or a Roth account is completely dependent on ones assumptions. There is absolutely no difference in outcome if tax rates remain the same.

    Don’t get me wrong, I understand you are implying that because workers don’t understand the difference, they will contribute the whole $100 to a Roth 401(k) and not realize it cost them more. It just seems to me that the article makes Roth accounts seem more magical than they are and the particular sentence above only works if those same people give up some spending and consuming before retirement.

    Not knowing what future tax laws will be nor what tax bracket we’ll be in during retirement means we are all making a big fat guess as to which one is best…which is why I do both.

  8. Murray Gendell says:

    A Roth has 2 big advantages: (1) both the after-tax funds put into it, as well as all the investment gains, are NOT taxed; and (2) tax-deferred accounts, but NOT Roth, are subject to minimum required distributions (MRD). MRDs deplete your invested capital. And as you get older, this occurs at increasing rates. For those unfamiliar with the MRD rules, this is because MRDs are calculated by taking the balance in your account(s) at the end of the preceding year and dividing that by a number the IRS supplies. These numbers are based approximately on official national life table data. And because your remaining life expectancy decreases as you get older,the divisor does also. For example, at age 80 it is 18.7, at 85 it’s 14.8, and at 90 it is 11.4. This means that at age 80 you must take out of your account(s) about 5.3% and at 90 about 8.8% of your capital, subject to ordinary income tax rates.