We often use this space to document the many cognitive biases that pull people off track with their investments. However, there’s one such bias — or perhaps it’s just blissful ignorance — that seems to be working in some investors’ favor. As The Wall Street Journal reported recently, people who choose the Roth version of their employer’s 401(k) plan tend to get even more for their money than they may realize.
A rational world
As you may know, a key difference between a traditional 401(k) and a Roth is when taxes are due. With a traditional account, investors get a tax deduction for their contributions but then owe tax when they withdraw from the account in retirement. With a Roth, there are no deductions for contributions, but then there are no taxes due when the money is withdrawn down the road.
If we were purely rational beings, such differences might sway how much we choose to contribute.
Investors using a Roth 401(k) plan could decide to contribute less than if they were using a traditional plan. After all, they won’t need to contribute as much because they won’t need as large a nest egg as they would have needed if they had used a traditional 401(k) plan.
For example, let’s envision a 30-year-old using a traditional 401(k) plan to build a retirement account that can provide him with $40,000 of after-tax annual withdrawals starting at age 70, assuming a 4% withdrawal rate. If he were in a 25% tax bracket in his later years, he would need an account balance of $1.333 million (4% of $1.333 million is $53,333, with $13,333 due for taxes). That would require annual contributions of about $6,250, assuming a 7% average annual return.
Now let’s envision another 30-year-old with the same goal but who decides to use a Roth 401(k). At age 70, her account would need to total just $1 million (4% of $1 million is $40,000 and no taxes are due). Assuming the same 7% average annual return, our Roth investor can get there by contributing just $4,680 per year.
The real world
It turns out there’s a big difference between what Roth investors could do differently than traditional retirement account investors and what they actually do, and that’s a good thing.
As reported in The Wall Street Journal, Harvard’s study of large employers (those with 10,000 or more employees) found that when deciding how much to contribute to a 401(k) plan, investors usually ignore the tax differences between traditional and Roth 401(k) plans. Instead, regardless of which plan they use, they rely on one of several common rules of thumb, such as contributing enough to receive the full match provided by their employer or saving a set percentage of their salary, such as 10%.
The Roth 401(k) plan investors, who could logically choose to set aside less than the traditional 401(k) investors, do not make that choice. By investing just as much, they end up with even more purchasing power in retirement.
What to make of it
The Harvard study should not encourage Roth investors to start contributing less to their retirement plans. Instead, it raises a couple of important points for traditional 401(k) plan investors.
Most importantly, it’s essential to prepare for your future tax bill, perhaps by using some of your current tax savings to invest even more in your 401(k) plan.
Secondly, don’t allow what may seem like overwhelmingly positive articles about the benefits of Roth 401(k)s to persuade you that the traditional versions are inherently second-class investment vehicles. Especially for investors in a high tax bracket, the current tax savings of using a traditional 401(k) may provide the necessary cash flow to be able to pursue other goals, such as saving for your children’s future college costs.
To be sure, there are a lot of factors to consider when weighing the traditional/Roth decision. How has the tax treatment of such accounts influenced your decision of which one to use?