Do Roth and 401(k) Pre-Tax Holders Really Spend Differently?

An interesting—and somewhat counterintuitive—report came out last week, one that cast doubt on the “common wisdom” regarding Roth versus traditional pre-tax savings.

The assumption underlying the research[i] was that those who had not yet paid taxes on their savings (the traditional pre-tax savings) would be hesitant to tap into those savings and trigger taxes, certainly more so that individuals that had already paid those taxes. Instead, the research suggested that the opposite occurred; that individuals who had saved on a pre-tax basis actually withdrew more/sooner—but with a twist. 

This they hailed as good news. They noted that the research suggests investing in a CT (current-taxed, or Roth) plan could help ease concerns about outliving funds—because they spend at a lower rate (though they saw this as a negative for those who saved on a deferred tax (DT) basis).  They even managed to find a silver lining in the “cloud” of faster spending by the pre-tax crowd because those individuals appeared to be trying to adjust for the effect of taxes (with the caveat “despite our findings that they do not appear to adjust sufficiently, if at all”). And they saw as a positive this report’s contribution to the “accounting literature exploring the effectiveness and consequences of incentivizing behaviors through tax policy, by highlighting how past decisions motivated by taxes (e.g., retirement plan type) may continue to affect one’s quality of life long into the future.”

A few words of caution would seem to be in order, however. This wasn’t based on the patterns of actual people spending their actual money in the real world. Rather, and to their credit, they constructed a laboratory environment of sorts; they selected a group of volunteers, gave them certain criteria—basically a role they would “play” in the experiment—and set out a spending scenario. They then had them read about various spending choices—and, well—recorded how the individuals chose.

As for their conclusions, when you probe into the results more carefully, what you see is that even though those who had pre-tax accounts ostensibly feel the “pain” of taxes due on their retirement withdrawals—and that appeared to restrict their spending—it seemed to be offset by another reality. That, for reasons not understood/explained, those same individuals appeared to relish the expected benefits of consumption more than Roth holders. Said another way, their “reservations”— the cognizance of taxes—didn’t seem to constrain their spending because they were (more) enamored of the benefits of spending. Indeed, the researchers commented that those with “equivalent nominal balances” actually spent at the same rate.

I’ll just comment that it’s an interesting premise—and that the test environment created struck me as detailed and complex to map out, establish and execute. That said, I would be hesitant to draw any substantive conclusions on actual human behavior from this analysis. To me, all it seemed to “prove” is that people selected for an experiment tend to spend to the perceived “limits” of their hypothetical account, regardless of taxation. It didn’t strike me that Roth holders spent less (as many headlines covering the report suggested), but rather that pre-tax holders spent the same, even though they were going to have to deal with a tax bill at some point (hypothetically, of course).

And that, to me, isn’t a positive thing for Roths so much as it is a cautionary note for pre-tax savers—who may have forgotten that tax deferral is just that.

 - Nevin E. Adams, JD

---

[i] How Does Tax Timing Affect Spending in Retirement?  

Hypothetically Speaking

A new academic study offers some insights on taxpayer preferences for pre-tax versus Roth savings – at least in certain conditions.

The study – which carries the somewhat unwieldy title “The Relative Effects of Economic and Non-Economic Factors on Taxpayers’ Preferences Between Front-Loaded and Back-Loaded Retirement Savings Plans” – takes a look at the various factors influencing preferences for paying taxes “up front” on retirement savings (this is termed “back-loaded by the researchers, in that the tax advantages come in retirement) versus pre-tax treatment as with a 401(k).

Writ large, and pretty much across the board, the researchers – Andrew D. Cuccia, associate professor and a Grant Thornton faculty fellow at the University of Oklahoma, and Marcus M. Doxey and Shane R. Stinson, both assistant professors at the University of Alabama – found that individuals preferred Roth (back-loaded) – even in circumstances in which they thought a rational determination would favor a pre-tax option.

“Consistent with prior research, our results suggest that individuals, on average, do not respond rationally to the relative economic incentives associated with alternatively structured plans,” they wrote. And while “at least part” of the “failure to connect relative tax rates – those paid now versus those in the future – was attributed to “a lack of awareness and/or understanding,” the researchers found individuals largely reluctant to embrace the pre-tax approach, even when education specifically designed to help frame that understanding was employed. Or, as the researchers explained, “… although errors can be reduced with increased awareness, our evidence illustrates that individuals systematically incorporate non-economic factors into their retirement plan choices, often leading to a preference for [pre-tax deferrals] even when such a choice is economically adverse.”

The researchers determined that “participants do not incorporate expected tax rate changes into their plan choice without an explicit explanation of the impact tax rate changes have on relative after-tax returns,” and “even when participants were educated about the tax rate change-return relation, 49% who reported that they expected their tax rates to be lower in retirement nonetheless elected to make their contributions to a back-loaded (Roth) plan.”

Now, in fairness the research wasn’t based on actual administrative data – rather they constructed several scenarios to test responses to various factors, and ran a group of online survey respondents through those scenarios to evaluate and weigh those responses. So, it was basically asking individuals about their (hypothetical) response to a variety of conditions regarding (hypothetical) tax rates, market conditions, as well as non-economic attitudes and preferences.

While they found a general preference for the back-loaded Roth accounts, they found “mixed evidence regarding whether individuals appropriately weight expected tax rate changes in their plan choices,” even though tax rates were seen as the primary factor driving the relative after-tax returns of front- and back-loaded plans. Indeed, the certainty of knowing the tax rate that would be paid, even if paid “now” seemed to outweigh the concerns associated with the uncertainty of future tax rates, though those who did expect to pay higher taxes in the future were – as one might expect – inclined toward the back-loaded (Roth) option.

If the researchers seemed puzzled about some of the preferences for the Roth option, they also found that a sense of urgency regarding saving for retirement was “positively associated” with savings rates, and that perhaps what they saw as “the current crisis in retirement preparedness” suggested to them that “current marketing and education campaigns are not sufficiently stoking investors’ sense of urgency.”

Those of us who work with retirement plans – and retirement plan participants – might not be quite so perplexed by the notion that individuals don’t always act in their financial best interest.  Additionally, while the researchers seemed to be quite thorough in outlining (and doubtless executing) their test scenarios, it is arguably one thing in a “laboratory environment” to make a choice with someone else’s money, and perhaps something else again to make those same choices with your own retirement savings.

Still, those concerned about a negative response by participants to the imposition of a Roth choice, might find some comfort in these findings.

Hypothetically speaking, of course.

- Nevin E. Adams, JD

Here We Go Again ...

What were you doing in 1986?

It was a big year in my life. I got married, hit one of those birthdays with a zero in it, watched my-then hometown Chicago Bears dominate Super Bowl XX, and picked up and moved my new bride (and our menagerie) several hundred miles south to take on a new job heading up a recordkeeping operation.

Before the end of that year, that recordkeeping operation (and, thanks to a recent bank acquisition, the seven different platforms it was running on) would be struggling to understand, implement and communicate a wide array of sweeping changes associated with the Tax Reform Act of 1986. Even though it came during a period when tax code changes (ERTA, TEFRA, DEFRA, REA), were being thrown at us about every 18 months, on average, it’s still difficult to absorb the scope and breadth of the work it took to implement the changes that came with TRA 86.

For all the work that had to go into complying with the new regulatory regimen that came with TRA 86, its real impact would come in the years that followed, via the newly established 402(g) limit (back then we simply called it the $7,000 limit), not to mention the multiple iterations of the nondiscrimination testing that often produced problematic refunds for the highly compensated group. There’s little question that those changes (and others) did what they were designed to do – generate additional tax revenue in the here-and-now by limiting the deferral of taxes.

Yes, the talk is all about tax reform, but the motivation is generally tax cuts, and with a $20 trillion debt, Uncle Sam will need to find some way to offset the projected loss in revenue – and that’s where the tax incentives to establish, fund and contribute to a workplace retirement plan inevitably find themselves in the budgetary crosshairs.

While those paying attention to such things realize that most of those tax preferences are temporary – that is, taxes will be paid on those employer, pre-tax contributions and the earnings thereon when they are withdrawn – the government bean counters look at revenues and expenditures within a 10-year window, and since the payment of most retirement benefits occurs outside that window, the amount of taxes postponed looks, from a budgetary standpoint, to be taxes permanently foregone. And, on that basis, even though the retirement preferences are completely different from other tax deductions, from a budgetary scoring standpoint, it’s a big, juicy target.

We saw what that might mean as recently as 2014 when then-Chairman of the House Ways and Means Committee Rep. Dave Camp (R-Mich.) put forth a proposal that would pay for tax reform (or at least some of it) by freezing the COLA limits that apply to defined contribution plans for a decade and limiting the annual ceilings on elective deferrals so that only half could be made on pre-tax basis (weirdly, this would have applied only to employers with more than 100 workers). The first part of the proposal was deemed to raise $63.4 billion in revenue over 10 years, the latter an additional $144 billion, by basically forcing workers who would otherwise have taken advantage of pre-tax savings to pay taxes on those contributions upfront. And let’s not forget that those burdens would have fallen particularly harshly on those who decide to offer these plans in the first place and to match employee contributions.

For those of us who remember 1986 – or perhaps the years in between that and EGTRRA – the references to TRA 86 as a model for Tax Reform 2017 are a bit chilling. Because when it comes to winners and losers in tax reform – and make no mistake, tax reform is all about winners and losers – more often than not, retirement comes out on the short end. And every time it does, it feels more than a little bit like having to bail out your brother-in-law with a loan from your 401(k) – again.

For months now we’ve been talking about tax reform, and the potential implications for retirement policy. It was a focus at this year’s NAPA 401(k) Summit, and it will be front-and-center at this year’s NAPA DC Fly-In Forum. The reason is obvious: If you’re going to lower tax rates and be revenue neutral, the money to offset those tax reductions has to come from somewhere. And traditionally, the tax preferences that foster the growth and expansion of retirement plans and retirement savings have been a “go to” source, perhaps never more so than a generation ago with TRA 86.

The road ahead could be rocky, particularly as it comes in the wake of the application of the Labor Department’s fiduciary regulation, whether delayed or not, and perhaps modified. It’s said that being forewarned is being forearmed, and we’ve certainly worked to do that over the last several months.
If you are not already, you’ll want to stay connected on these issues in the weeks ahead.

Get informed. Get involved. Before it’s too late.

- Nevin E. Adams, JD