New UA Eller Research Challenges Conventional Advice About Investing In Traditional And Roth Retirement Plans
Findings show a mix is optimal, and the largest economic benefits from Roth investments accrue to investors with high current income
TUCSON, Ariz. – August 22, 2016 – New research coming out of the University of Arizona Eller College of Management has important practical implications for retirement savers, suggesting that the advice that many investors are receiving is not optimal.
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The study, entitled Tax Uncertainty and Retirement Savings Diversification, was co-authored by UA Eller College finance professors Scott Cederburg and David C. Brown and University of Missouri finance professor Michael S. O’Doherty.
The professors developed software to account for tax uncertainty when analyzing investors’ contributions between pre-tax traditional and post-tax Roth versions of tax-advantaged retirement accounts. Historically, taxpayers have faced considerable uncertainty regarding future tax rates. Since 1913, for married taxpayers with an inflation-adjusted income of $100,000, the marginal tax rate has changed 39 times and ranged from 1 to 43 percent. By simulating one-million retirement scenarios over the next 30 years, the professors analyzed the relative benefits of traditional and Roth accounts.
“In this setting, traditional accounts are valuable for hedging retirement account performance and managing current income near tax bracket cutoffs, whereas Roth accounts allow investors to mitigate uncertainty over future tax schedules,” Eller’s Scott Cederburg said.
The research emphasizes that both types of accounts help to manage risk, but in different ways. Traditional accounts limit the negative impacts of return uncertainty. If investors experience low returns, they will have lower retirement income, and lower tax rates will reduce the sting of poor returns. Roth accounts limit the negative impacts of tax rate uncertainty. By locking in current tax rates, investors reduce their exposure to unknown future tax rates.
Historically, Roth accounts have been recommended to younger investors with low incomes while traditional 401(k)s have been the choice for older or wealthier workers. With traditional 401(k)s, contributions reduce current taxes, but withdrawals are taxable in retirement. Conversely, Roth contributions are taxed immediately, while withdrawals are made tax-free.
Cederburg said one of the most surprising outcomes of their research relates to implications for higher-income investors.
“More than likely, these investors have been told to allocate all of their funds into a traditional retirement account, but that advice doesn’t consider the risks of tax rates increasing,” Cederburg said, adding that investing some of their funds into a Roth account will eliminate some of that risk.
The professors hope employers will consider their research when offering retirement plans to employees. By providing access to Roth 401(k) accounts, employers give employees the ability to manage their tax-rate risk. According to Brown, accounting for tax-rate risk improves investors’ retirement prospects, “effectively saving them the equivalent of mutual fund management fees.”
“We’ve been fortunate in that the University of Arizona gave us the option of contributing to both types of accounts,” Cederburg, 34, said, adding that both he and Brown decided to hedge their bets and split their contributions between both traditional and Roth plans.
UA Eller’s Finance Department prepares undergraduate and graduate student for careers in corporate finance, investments, banking and real estate. For details, visit https://finance.eller.arizona.edu/.