To Roth or Not to Roth?
A new study looks at the benefits of both — and calls into question the conventional wisdom on who benefits most, and how participants should approach those options.
In “Tax Uncertainty and Retirement Savings Diversification
,” researchers from the University of Arizona and the University of Missouri note that in an economy with progressive taxes and tax-schedule uncertainty, both pre-tax and post-tax versions of retirement accounts provide relative advantages to savers, and the conclude that the optimal policies for most households involve diversifying across these accounts. As one might expect, they note that Roth accounts are specifically valuable for managing uncertainty about the future tax schedule.
Whereas conventional wisdom largely supports choosing between traditional and Roth accounts by comparing current tax rates to expected future tax rates, they explain that the hedging benefits of traditional accounts and the usefulness of Roth accounts in managing tax-schedule uncertainty are important considerations in the “optimal” savings decision.
The paper goes on to note that Roth accounts are typically recommended to low-income savers and young investors who expect their real income to grow, and that the conventional advice is, therefore, largely based on expected differences in current and retirement income and often emphasizes one type of account to the exclusion of the other.
However, they caution that this advice fails to account for an investor’s exposures to two sources of uncertainty in future tax rates. Specifically that, in a progressive tax system, an individual’s future marginal tax rate is unknown, but “plausibly correlated” with retirement account performance, more plainly that the more you withdraw from those accounts, the higher your resulting marginal tax rates.
Second, the overall tax schedule, including the number of tax brackets and the corresponding rates, may change significantly over time. For example, they write that a shift to a consumption tax system would favor traditional accounts relative to Roth, whereas a flat income tax structure would reduce the tax benefit of traditional investments and make Roth accounts more desirable. “Diversifying with traditional and Roth savings may help households balance these risks,” they explain.
They conclude that, in contrast to conventional wisdom, the benefit of the Roth is “particularly important” for high-income households, while traditional savings are “valuable for managing current-period taxable income and creating a favorable correlation structure between investment performance and marginal tax rates in retirement.”
Given these benefits, they conclude that the optimal asset location policy for most investors involves diversifying between traditional and Roth accounts.
They also note that the underutilization of the Roth option within 401(k) plans might be explained by “the lack of advice in the popular financial press and limited financial education.”