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

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

Cost Conscience

In about a month my eldest will be setting up a new home in a different state. It won’t be her first time living in another state, and it won’t be her first apartment. It will, however, be her first apartment as an entrant into the full-time career workforce, and so the criteria—and budget—are quite different than our past experience(s). And while she’s done a great job of constructing a budget (including savings), I can’t help but notice that she also spends “her” money a little differently than when Dad was footing the bill.

My daughter’s spending inclinations aren’t unusual, of course. As parents we tried to give our kids a sense of the cost of things, certainly as they grew older. There were, however, plenty of times over the years we didn’t share that information, either because it wasn’t important, or, in some cases, because we didn’t want them to make a decision based solely on price.

There’s a similar logic afoot with consumer-driven health plans (CDHPs). Advocates of these programs¹ contend that providing participants with an account and subjecting their health insurance claims to high deductibles will induce enrollees who would likely be spending more of their own money (than might be the case with traditional health coverage) to make more cost- and quality-conscious health care decisions. On the other hand, CDHP skeptics caution that these individuals lack the kind of information they need to make good decisions—and, worse, might make cost-centric choices that aren’t the best health care choice, and might even prove to be less cost-efficient (and even more expensive) over the longer term.

In one of the first studies of its kind, EBRI has analyzed detailed claims data over a five-year period from a large Midwestern employer that adopted a high-deductible health plan with a health savings account (HSA) for all employees in place of its traditional health care offering. The research, published in the July EBRI Issue Brief,² found that in this case, where the HSA plan was the only type of health plan the employer offered, the HSA reduced the plan’s total health care spending by 25 percent in the first year ($527 per person in the aggregate). Moreover, the cost savings continued over the succeeding three years—albeit at a slower pace.

The study also found that each category of health spending experienced statistically significant reductions in the first year of the HSA plan, with the exception of spending on inpatient hospital stays. Spending on laboratory services and prescription drugs had the largest statistically significant declines (36 percent and 32 percent, respectively). Indeed, reductions in pharmacy spending were large and mostly sustained over the four years after the HSA was adopted. In the first year of the HSA, pharmacy-spending reductions were 40–47 percent for individuals in all but the highest quintile of spending.

There are some limitations to what can be inferred from this particular study, which focused on the experience of a single large employer, and participants with continuous coverage throughout the study period, among other things. While it did not allow for distinguishing utilization of discretionary from necessary services, the data suggest that the highest users were least affected and that moderate users were most vulnerable. If the cost savings trends don’t necessarily speak to the quality of those health care decisions, the report clearly adds to the consumer-directed-health-plan literature, and our understanding of how these programs can influence cost and utilization—information that is essential to our understanding of the value of account-based, high-deductible plans.

After all, when you don’t know the cost of something, it’s hard to appreciate the value.

Nevin E. Adams, JD

¹ A recent EBRI report notes that employers have now been using CDHPs for over a decade. In 2012, 22 percent of smaller employers, 36 percent of larger employers, and 59 percent of jumbo employers offered some form of a CDHP, and nearly 1 in 5 workers were enrolled in one.

² “Health Care Spending after Adopting a Full-Replacement, High-Deductible Health Plan With a Health Savings Account: A Five-Year Study” is available online here.