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contrast, account holders get to deduct their contributions from their income, but taxes are due when those funds are withdrawn, usually during retirement and at a lower tax rate because the saver is no longer working.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)?
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?
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….