What’s more, Roth participation is more than twice as high among 401(k) participants who were hired after the Roth 401(k) was introduced in 2006 rather than among 401(k) participants who were hired before the Roth introduction, according to the authors of the study, John Beshears, James Choi, David Laibson and Brigitte Madrian.
By way of background, the Roth 401(k) is a retirement savings plan that represents a combination of features of the Roth IRA and a traditional 401(k) plan. This employer-sponsored investment savings account is funded with after-tax money, and after the investor reaches age 59½, withdrawals of any money from the account (including investment gains) are tax-free, according to Investopedia.
According to the study, Internal Revenue Service regulations stipulate that the combined before-tax plus Roth contributions in a calendar year cannot exceed a certain limit that is adjusted each year. For people younger than 50, this limit for 2013 is $17,500 in 2013; for workers 50 and older the limit is $23,000.
One reason why so few workers are contributing to Roth 401(k) has to do with the nature of humans, according to the study. “In essence, once an employee joins a 401(k) she becomes passive/inattentive, thereby reducing the likelihood of reacting to the introduction of a new Roth option,” the authors wrote. Read the paper.
So given that sort of inertia, and given the results of their study, we asked the authors how workers might approach the question of when and how to use a Roth 401(k). Here’s what they had to say.
Deciding whether to save in a Roth vs. a regular 401(k) savings account is not necessarily a straightforward decision because one type of account is not necessarily better than the other, said Madrian, a professor at Harvard Kennedy School.
“The primary difference between the two types of accounts is when you pay taxes,” she said. “With a Roth, you pay taxes on the income you save today but pay no taxes when you take money out of the account in retirement. With a regular 401(k), you pay no taxes on the income you save today and but you do pay taxes on the money you take out of the account in retirement.”
According to Madrian, the Roth is a more attractive savings vehicle if you think your tax rate is lower today than it will be when you retire. And the regular or traditional 401(k) is a more attractive savings vehicle if you think your tax rate is higher today than it will be in retirement, she said.
So what factors might sway you into preferring one vs. the other?
When to use a Roth 401(k)
“If you aren’t paying any federal income tax, you are not getting any tax benefit from saving in a regular 401(k),” said Madrian. “For you, a Roth 401(k) is a no-brainer.”
According to Madrian, employees who are likely to fall into this category: young employees who are just starting out and expect their income to grow over time, employees whose income is temporarily low perhaps due to an unemployment spell during the calendar year, and employees with a large number of exemptions and deductions that are unlikely to persist into retirement (for example, individuals with a lot of children, or a big mortgage).
When to use a traditional 401(k)
If, however, your tax rate is likely to fall in retirement, then a regular 401(k) makes more sense, Madrian said. “Saving in a regular 401(k) reduces your tax liability today when your tax rate is higher than it is likely to be in retirement,” she said. “This is more likely to be true for middle-income employees who expect Social Security to comprise a decent share their income in retirement.”
When to use both
And, if your tax rate is likely to be the same in retirement as it is today, then you fare the same with either type of account, said Madrian. “If you feel like your taxes could be either higher or lower in retirement, then a tax diversification strategy would be to contribute to both a Roth and a regular 401(k) account,” she said.
Note too, Madrian said, that if your employer offers a match, the matching contributions will be directed to a regular 401(k) account regardless of what you choose for your own contributions. “So even if you contribute to a Roth account, you have some tax diversification built in through the tax treatment of the employer match,” she said.
Madrian’s co-authors share this point of view. “If you are in a lower income tax bracket and are trying to decide whether to save in a regular before-tax 401(k) or a Roth 401(k), the good news is that many employers allow you to do both, and it’s not a bad idea to contribute to the two account types simultaneously,” said Beshears, a professor at Stanford University. “The reason is diversification.”
We invest, Beshears said, in stocks and bonds at the same time because sometimes one goes up while the other goes down, so buying both helps smooth out the bumps. “Similarly, contributing to a before-tax 401(k) is beneficial if your tax rate goes down (you pay taxes later), while contributing to a Roth 401(k) is beneficial if your tax rate goes up (you pay taxes now), so contributing to both helps smooth out the benefits no matter which way your tax rate goes,” he said.
Other reasons to contribute to a Roth 401(k)
The Roth 401(k) is also good for people don’t want to draw down their retirement accounts during their life, said Laibson, a professor at Harvard University. Roth accounts are not affected by the required minimum distribution (RMD) rules during the owner’s life, he said. Owners of traditional IRAs must take RMDS after turning 70½.
Laibson also said Roth 401(k)s are appropriate if you are very wealthy and your estate will exceed the estate tax exemption. “Moving assets from a regular 401(k) to a Roth 401(k) will reduce the size of your estate, since you pay taxes when you move the assets or when you contribute to a Roth in the first place,” he said “These tax payments come out of your estate, reducing your estate tax obligation.”
Decision not without complications
To be fair, deciding whether it makes sense to contribute to Roth 401(k) isn’t as easy as it sounds. “It’s actually very hard to calculate your current marginal tax rate, because income-based phaseouts of government benefits and tax deductions can raise effective marginal tax rates in unexpected and complicated ways,” said Choi, a professor at Yale University. “This really complicates matters because a key input into your Roth vs. before-tax 401(k) decision is whether your current effective marginal tax rate is higher than what it will be in retirement.”
(Read Americans’ 90% tax rate, Income Tax Issues: How do phaseouts of tax provisions affect taxpayers?, Read tooThinking About a Roth 401(k)? Think Again.)
Another complication is the existence of a 401(k) match. “For many people, the 401(k) match will make Roth contributions relatively less attractive, since each dollar of effective post-tax retirement savings is matched at a lower rate for Roth contributions than before-tax contributions,” Choi said.
Upping your retirement savings
Of course that can work to a worker’s advantage, too. If you are among the few contributing the maximum amount allowed to a regular 401(k) and wish you could contribute more, a Roth account is one way to increase your effective saving, Madrian said.
“The contribution limit is the same for a Roth vs. a regular 401(k), but since you don’t have to pay taxes on the Roth in retirement, $1 saved in a Roth buys more retirement consumption than $1 saved in a regular 401(k),” she said. “The extra retirement consumption isn’t a free lunch—you have to pay taxes on your Roth contributions today. If you’re at the 401(k) contribution limit and your tax rate in retirement is not likely to fall from what it is today, the Roth account allows you to purchase more retirement consumption than a regular 401(k) account.”
Some 20% of workers are contributing to the annual maximum limit, according to Bank of America Merrill Lynch’s 2013 Workplace Benefits Report.
What if tax rates rise?
To be sure, some think that the fiscal situation in the U.S. is likely to result in higher income-tax rates going forward. And that could complicate matters a bit. “If tax rates are increased across the board and your income in retirement does not fall enough to put you into a lower tax bracket, then a Roth would be a better option,” said Madrian.
But Madrian cautioned that it’s anyone’s guess how the U.S. government will address the problem of federal debt going forward. “They could focus on Social Security and increase payroll rather than income taxes, they could increase income taxes for everyone, or they could increase income taxes for some but have a system of allowances or exemptions that allow the burden of higher taxes to fall disproportionately on the employed rather than the elderly,” she said.
Worth talking to an expert
The truth of the matter, however, is this: Broad brush bromides might not be in your best interest. “It’s hard to give succinct advice in this matter, because each person’s relevant circumstances can vary considerably and there’s so much uncertainty about what future tax law will be, said Choi.
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