People end up saving at the same rate with both—giving the advantage to Roth
Wall Street Journal, by Demetria Gallegos
New research shows that employees who choose a Roth 401(k) from their company’s menu of retirement plans might end up with more purchasing power in retirement than if they pick a traditional 401(k).
The Roth 401(k) is a relatively new offering, available just since 2006. Deposits in the Roth account are after-tax, so the savings grow tax-free. With traditional 401(k)s, by contrast, account holders get to deduct their contributions from their income, but taxes are due when those funds are withdrawn, usually during retirement and at a lower tax rate because the saver is no longer working.
Both accounts have their advantages. But when researchers at Harvard Business School looked at Roth 401(k) accounts across a range of industries at companies with 10,000 or more employees, they found that savers using Roths ended up ahead. The reasons were surprising.
We asked the lead author of the forthcoming study, John Beshears, a behavioral economist and assistant professor of business administration at Harvard Business School, to explain. Edited excerpts of the interview follow.
WSJ: What did you find for people who used the Roth 401(k) option, compared with those who used the traditional 401(k)?
MR. BESHEARS: What we found is that people didn’t save any differently, in the sense that they still had the same total contribution rate. But with the Roth 401(k), that actually translates into more purchasing power in retirement.
WSJ: Why is that?
MR. BESHEARS: The American tax system is extremely complicated. People very reasonably use rules of thumb to guide their financial decisions, especially in the face of complexity. Some common rules of thumb for saving in a 401(k) are to contribute the amount necessary to earn the maximum employer matching contribution, or to contribute the maximum amount allowed in the plan. Another ubiquitous suggestion is to save 10% of pretax income. If they switch over into a Roth and do not adjust their rule of thumb, they’re in effect saving more.
WSJ: Walk us through that.
MR. BESHEARS: It feels like you’re following the same rule—I’m saving 10%. But it makes a big difference if you’re doing it in the traditional 401(k) or the Roth.
In the case of the traditional 401(k), taxes are still due when you withdraw money in retirement. In fact, you are probably in a lower tax bracket in retirement, so you pay taxes at a lower rate than when you were working. In a sense, you could have put more money in the account back when you were working to cover future taxes, but you didn’t because no one does that if they’re following a rule of thumb.
But in the case of the Roth 401(k), the whole amount is yours in retirement. You could have put in less money back then because you had to pay taxes due at that time, but you didn’t, again because of the rule of thumb. The Roth fund is worth more because every single dollar in the account can be withdrawn tax-free.
WSJ: So what kind of difference are we talking about, come retirement?
MR. BESHEARS: If a worker saves $5,000 a year in a 401(k) for 40 years and earns 5% return a year, the final balance will be more than $600,000. If the 401(k) is a Roth, the full balance is available for retirement spending. If the 401(k) is a traditional one, taxes are due on the balance. Let’s say the person’s tax rate is 20% in retirement. That makes for a difference of $120,000 in spending power, which a life annuity will translate into about $700 a month in extra spending.
WSJ: So investors are almost accidentally saving more on a Roth 401(k) by keeping round numbers to meet their rule-of-thumb goal.
MR. BESHEARS: Indeed, it’s just a difference of whether you’re paying your taxes now or later. With the Roth 401(k), you’re paying the taxes now. You’re sacrificing today for more spending power in retirement.
WSJ: Do you recommend the Roth 401(k) over the traditional pretax option?
MR. BESHEARS: That’s a more complicated question, whether people should use it. We studied what happened when they do use it. We’re not recommending the Roth 401(k) necessarily, but it does seem conducive to increased savings.
WSJ: Do your findings on Roth vs. traditional 401(k)s apply to Roth IRAs vs. traditional IRAs as well?
MR. BESHEARS: They absolutely translate.
If people have a rule of thumb for the number of dollars they put into these savings vehicles, the exact same implications follow.
Ms. Gallegos is a news editor for The Wall Street Journal
Using retirement savings to delay taking Social Security can pay off thanks to the program’s incentive.
It's widely considered one of the best investments a near-retiree can make – delaying the start of Social Security benefits to 66 or 70 instead of 62. The delay provides a guaranteed investment gain by increasing the benefit 8 percent a year, a return that in most cases can only be matched by taking much greater risks on stocks.
What if you want to retire at 62 or 66? Many experts say the benefit of postponing Social Security is so good that it's worth tapping investments until Social Security checks start.
But what happens to the benefit if you stop earning income? How will that affect the amount you receive later?
It could reduce your payments, but in most cases not by much, says Jack Shinn, of J Shinn & Associates, a financial consulting firm in Glen Rock, New Jersey. "Any losses of income at this stage – or increase, for that matter – is probably not enough to have a significant effect on benefits," Shinn says.
Experts caution, however, that eliminating some potentially high-paying years from your income history could have a significant effect if you have paid into the system for fewer than 35 years.
The payoff from postponing Social Security is clear. A person eligible for a $1,000 monthly income at 66 would get just $750 by starting at 62, but could get $1,320 by waiting to 70. Of course, the person receiving the bigger payment would also miss out on many payments during the wait. That means the longer you live the more likely the bigger payments will offset the money lost during the delay. In the example, the break-even point from waiting to 70 rather than 66 would be age 79, when the extra $320 a month would make up for the $36,000 missed during the wait.
Many who are forced to retire because of health or a cut back at work, or to join a retired spouse, may opt to start Social Security as soon as possible because they need the money. Many people, however, are capable of living without Social Security for a few years.
But although that can increase the benefit as described, retiring before the benefit starts also reduces the number of years you pay into the system.
The benefit estimates you get from the Social Security Administration assume your income will continue at its most recent level until you retire. If you cut back or stop earning entirely before full retirement age, which is 66 or 67 for most people still working today, that will affect the benefit calculation.
But for most people that will not undermine the benefit very much, most experts say. That's because it is calculated using the worker's 35 highest-paid years. Retiring early can eliminate some high-income years if you're at your peak in your 60s, but most experts say stopping work or downshifting to a lower-paying job generally has little effect because the formula uses average income over 35 years, and adjusts each year for wage inflation. While your income at 60 may look huge next to your income at 25, the difference narrows significantly after inflation is taken into account.
And because so many years are considered, a few extra years late in your working life, replacing lower-paid years from your youth, will not have that much impact.
"For someone who has a solid 35-year work record, and is at or near the maximum Social Security benefit, downshifting would have little effect as they would still have 35 decent years applied toward the maximum benefit," says Bill Elson, a planner with Spectrum Advisory Services in Des Moines, Iowa.
But he warns that people with shorter work histories should be cautious about stopping work too young.
"For someone who does not have 35 years of work, it could have a larger effect," Elson says.
A person who had withdrawn from the workforce to raise children and had therefore paid into Social Security for only 20 years, could give up a lot by eliminating four or five years of income during his or her highest-earning period at the tail end of a career, for example.
Benjamin M. Westerman, a planner at HM Capital Management in Clayton, Missouri, says clients often resist his urgings to postpone Social Security, even when presented the numbers.
"The greatest challenge advisors will have in convincing clients to delay Social Security is a behavioral finance quirk," he says. "Even if it makes sense from a long-term financial perspective, most people would rather delay withdrawing from their nest egg and take Social Security early or at full retirement age, as it feels better delaying pulling money from retirement accounts."
Withdrawing from retirement savings in order to delay Social Security can make sense if those savings are not growing as fast as the 8 percent earned on a Social Security postponement. Also, Westerman adds, people who have stopped work tend to be in low tax brackets, stretching the value of money taken from individual retirement accounts and 401(k)s.
Paul Ruedi, CEO of Ruedi Wealth Management in Champaign, Illinois, emphasizes that Social Security benefits grow with inflation, so that the postponed benefit will not only be bigger at the start but will grow to keep up with a rising cost of living. There's no guarantee your regular investments will do that, making a Social Security delay a form of "longevity insurance" – valuable if you live longer than expected.
So, bottom line: If you've contributed to Social Security for 35 years, or close to it, you may give up little or nothing by quitting work or downshifting and not making sizeable contributions going forward. In fact, you're likely to come out way ahead by delaying the start of your monthly check by a few years.
But if your work history is substantially shorter than 35 years, adding a few years by staying on the job could pay off by increasing the average income used to figure your benefit.