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?  

'Tacts' Treatment?

Roth 401(k)s are more prevalent—and popular—than ever. But is that good—or bad—for retirement?

A recent op-ed[i] in The Wall Street Journal explored the potential implications—“What ‘Rothifying’ 401(k)s Would Mean for Retirees”— (subscription required), though the focus is on tax policy as well.

You’ll remember that so-called “Rothification”—essentially the elimination of the pre-tax treatment currently accorded 401(k) contributions—was quite the controversial issue back in 2017 when the Republican-controlled House of Representatives was looking for ways to raise revenue to help pay for tax cuts.[ii] And while it’s not been an active focus of late, it seems likely to resurface as the nation’s budget deficit widens, and the field of 2020 presidential aspirants seem determined to find ways to spend more or, in the case of the incumbent, collect less in taxes.

‘Out’ Comes 

As for the WSJ treatment, I’ll spare you the short read (longer if you actually check out the 36-page paper it was based upon), and summarize it thusly: later retirements (not by choice, but of necessity), less retirement income, and more wealth inequality. Though, at least in the short run, more tax revenue for Uncle Sam.[iii]

Now most of this comes from a key assumption; as the WSJ piece puts it, “Over their lifetimes, workers would accumulate one-third less in their 401(k)s under a Roth system. This is because, with no tax advantage from contributing to a 401(k), workers would save less and those lower contributions would earn less over the years.”

Said another way, without the tax break, the authors conclude that workers won’t save as much, and saving less means that they’ll have less invested, and that  means that they’ll have less retirement income. They also argue that, with Rothified savings, workers would tap into Social Security later—a year later, on average, they claim. They note that with their retirement savings already taxed, wealthier individuals would be inclined to defer taking Social Security (increasing their benefit), widening income inequality.[iv]

‘Less’ on Plan?

The concern about mandatory Rothification was always that workers would, in fact, save less—and this is a concern that employers have expressed, though this was in the context of the ability to save on a pre-tax basis being taken away. That, in turn, seems to be predicated on the notion that workers have a specific dollar amount in mind that they can afford to save, and that if some of that certain dollar amount goes to taxes, there is a dollar-for-dollar offset. Doubtless that’s true for some, particularly among lower-income workers. However, when I have seen savings data, what seems to be the norm is that individuals save a specific percentage of pay, one generally driven either by what’s necessary to earn the employer match, or perhaps that rate at which default contributions are set. In other words, people choose to save 3% of pay, not $50/paycheck.

Now, if that  perception is accurate (feel free to disagree in the comments below if you see things differently), then it seems to me that most individuals might actually save the same amount, regardless of whether it’s pre- or post-tax. And if they were to same at the same rate (and admittedly that’s a big “if”), their retirement outcome might actually be more  secure—because withdrawals (and taxation) wouldn’t be forced on them by RMD calculations, because they wouldn’t have to worry about those contributions—and the earnings that have accumulated on those contributions—being taxed, and, significantly, because the reduction in taxable income wouldn’t undermine (through “means testing”) Social Security benefits.

But key to the analysis is how participants would respond, and the study cited in the WSJ isn’t the only academic consideration on the subject; one in 2015 found no change in savings rates with a voluntary addition of a Roth feature, and in 2017, the non-partisan Employee Benefit Research Institute (EBRI) found that it might help—or hurt—retirement security—and this is key—depending on the response of participants.

It appears that more participants are being presented with that option. Nearly 70% of plans now provide a Roth 401(k) option, according to the most recent survey by the Plan Sponsor Council of America. Perhaps more significantly, that survey, reporting 2018 plan activity, finds that nearly a quarter of participants (23%) elected to contribute to a Roth when given the opportunity, up from 19.5% in 2017 and 18.1% in 2016—an increase of nearly 30% in just three years.

Academic studies notwithstanding, it’s worth remembering that retirement security isn’t just a matter of how much you have saved at  retirement; it’s how much you have available to spend throughout retirement.

- Nevin E. Adams, JD

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[i]The authors of the WSJ article, Olivia S. Mitchell and Raimond Maurer, previously authored a research paper upon which the WSJ piece was based (albeit with a slightly different title, “How Would 401(k) ‘Rothification’ Alter Saving, Retirement Security, and Inequality?”). 

[ii]They weren’t, however, the first to propose such a shift. President Obama did so in 2015.

[iii]However, the authors state that the taxes collected on withdrawals of that money exceed the amount of additional income taxes that would be collected during people’s working lives under Rothification.

[iv]As a side note, the authors in the WSJ article note that not only would this be bad for Social Security funding, but they also conclude that the taxes collected on withdrawals would exceed the amount of additional income taxes that would be collected during people’s working lives under Rothification—ostensibly because of their previous assumption that it would be a larger accumulation of money to be taxed. 

Road "Construction"

The Senate Finance Committee is positioned to pass a highway bill, funded at least in part by changing the tax treatment on retirement accounts.

Specifically, the modified chairman’s mark of the proposed Highway Investment, Job Creation and Economic Growth bill would require that age 70-1/2 account distributions be treated, for tax purposes, as distributed within five years of the death of the account holder (unless the beneficiary is the account holder’s age, a child with special needs, or older than 70).

Under current law, holders of IRAs and 401(k)-type accounts are required to begin taking taxable distributions from those accounts once they reach age 70-1/2, though if the account holder dies, the taxation of the account is spread over the life of the beneficiary. According to a Senate Finance Committee press release, this particular provision is estimated to raise $4.648 billion over 10 years.

The bill’s prospects in the Senate remain unclear, and the Wall Street Journal notes that the House version does not contain the retirement account tax change. However, the Senate provision demonstrates how the current budgetary and economic pressures in Congress—particularly in an election year—make the tax treatment of retirement savings a major target for any number of legislative initiatives, including those that have little or nothing to do with retirement.

The Employee Benefit Research Institute (EBRI) has long provided a credible and objective source of information for both policymakers and regulators, including recent testimony provided to:

• The Senate Finance Committee on “Tax Reform Options: Promoting Retirement Security”, and “The Impact of Modifying the Exclusion of Employee Contributions for Retirement Savings Plans From Taxable Income: Results From the 2011 Retirement Confidence Survey.”

• The Senate Committee on Health, Education, Labor, and Pensions on “The Power of Pensions: Building a Strong Middle Class and a Strong Economy,” and

• The House Committee on Education and the Workforce, Subcommittee on Health, Employment, Labor, and Pensions, regarding “Retirement Security: Challenges Confronting Pension Plan Sponsors, Workers, and Retirees.”

The impact of certain tax reform proposals was evaluated in the November 2011 EBRI Issue Brief, and will be updated to include input from the 2012 Retirement Confidence Survey next month.

- Nevin E. Adams, JD


The Employee Benefit Research Institute is a private, nonprofit research institute based in Washington, DC, that focuses on health, savings, retirement, and economic security issues. EBRI offers a unique perspective in that we do not lobby nor take policy positions. The work of EBRI is made possible by funding from its members and sponsors, which includes a broad range of organizations involved in benefits issues. For a full list see EBRI’s Members.