"Behavioral Finance" Provides Another Reason to Consider the Roth 401(k) Option

December 19, 2005

By Barry R. Milberg

"Behavioral Finance or Behavioral Economics" is another reason why the Roth 401(k)/403(b) should be considered by plan participants regardless of their income level.  Here's what Wikipedia, the free encyclopedia, has to say about these relatively new fields of study:

"Behavioral finance and behavioral economics are closely related fields which apply scientific research on human and social cognitive and emotional biases to better understand economic decisions and how they affect market prices, returns and the allocation of resources.  The fields are primarily concerned with the rationality, or lack thereof, of economic agents.  Behavioral models typically integrate insights from psychology with neo-classical economic theory."  Learn more

These fields of study advance the theory that many of us spend available cash frivolously in lieu of saving.  Think "buy term insurance and invest the difference."  How many of us invest the money we save?

How does this apply to the new Roth 401(k) option?

We know if a participant chooses the Roth option, and wants the same net take home pay, the Roth contribution is lower than the pre-tax contribution because tax is paid now on the salary reduction before it is contributed to the Roth account, or simply stated... Same Net Pay means Lower Roth Contribution

Conversely if a participant wants the same dollar amount contributed to a Roth account as compared to a pre-tax account, the net take home pay is lower because the salary reduction is higher to pay federal income taxes before the contribution is deposited into the plan, or simply stated...  Same Contribution to Roth means Higher Salary Reduction, and therefore...

The Roth Option Promotes Saving More for Retirement

Here's why...

Example:  Same Net Pay Means Lower Roth Contribution A male participant age 51 and earns $350,000 annually; however, for retirement plan purposes, his compensation is capped at $220,000 (the 2006 compensation limit). He pays taxes on his last dollars earned at the federal rate of 35%.  He defers 9.1% of compensation, or $20,000, into a pre-tax 401(k) account. If he wants to have the same net pay after contributing to the Roth option, what is his after-tax Roth contribution?  He reduces his pay by the same gross amount of $20,000, pays $7,000 in tax on the $20,000 (35%) and contributes $13,000 to the plan. 

Example:  Same Roth Contribution Means Higher Salary Reduction  Same facts as the previous example except the participant contributes $20,000 to the Roth account.  If the participant contributes the $20,000 maximum to the Roth account, what is his salary reduction?  The participant reduces his pay by $30,679, pays $10,769 in tax (35%) and contributes $20,000 or $7,000 more in after-tax dollars to the Roth account than in the previous example.

Pay close attention to the $7,000 differential;

it's key to understanding this puzzle.

Let's first examine the prospective future changes in the participant's marginal tax rate (MTR) and their impact on his total after-tax retirement distributions resulting from 5 years of the $13,000 contributions to the Roth account compared to $20,000 contributions to the pre-tax account.

The analysis indicates that if the participant's tax rate is the same following retirement as it was when he made the contributions, both options provide the same total retirement benefit.  If the participant's tax rate goes down, the pre-tax option was the right choice; if his tax rate goes up, the Roth was the right choice. 

Next let's examine the outcomes following retirement of $20,000 contributions to both accounts.  As we determined, the $20,000 Roth contribution decreases the participant's paycheck by $30,769 as compared to the $20,000 contribution to the pre-tax account, which decreases his paycheck by only $20,000.  However, to formulate a sound comparison of the $20,000 maximum contribution to the Roth versus a $20,000 maximum contribution to a pre-tax account, we must consider that it costs $10,769 more to contribute to the Roth.  Therefore, we’ll invest the $7,000 after-taxes are paid on the $10,769 difference in a side fund.  The side fund benefits are combined with the pre-tax benefits and compared to the Roth benefits to formulate a sound comparison.

The outcome considering the side fund is not what one might suspect.  The participant's outcome is better when selecting the Roth option even if his MTR decreases from 35% to 28%, and it is significantly better if his MTR remains at 35% or it increases to 42%. 

The reason for this unexpected outcome is the participant's ability to invest in various asset classes within the tax-free Roth environment.  Assuming comparable risk factors attributable to the selected investments, it is virtually impossible for a taxable side fund to perform as well as the tax-free Roth.  For example, a very conservative after-tax investor might earn 4% in a tax-free bond; whereas, with a comparable level of risk, that same investor could earn 5.5-6% tax-free by investing in a taxable bond within the Roth environment.

Commentary  Choosing the Roth option promotes this participant to effectively save an additional $7,000 towards retirement.  It's the ability to invest the $7,000 (or less dependent on your age and tax rate) in taxable investments within the tax-free plan environment that makes the Roth the preferred choice for participants of all income levels since it promotes saving more for retirement. 

To a great extent this analysis is infallible for those who are already saving the maximum permissible amount in their plan.  It is not to imply that many who are not maximum savers would not achieve a better outcome if they contributed a higher amount to a pre-tax account.  It's just that most of us do not "behave" that way when it comes to financial decisions.  The Roth provides a "psychological" push which can go a long way towards making one's life more secure in retirement.  And...

Since the participant can rollover the Roth 401(k) account into a Roth IRA, it also provides far more flexibility relative to distribution planning since Roth IRAs are not subject to minimum distribution requirements. 

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