Those enrolled in traditional 401(k) savings accounts might exhaust their savings faster than those allocating to a Roth 401(k), finds new research from the American Accounting Association.
The paper, “How Does Tax Timing Affect Spending in Retirement?” questioned whether “deferred-tax” (DT) or “currently-taxed” (CT) accounts could sway participant behavior when spending during their golden years. “We wanted to see if the decision to use DT or CT accounts influences the way people spend money in retirement,” says Shane Stinson, co-author of the study and an associate professor of accounting at the University of Alabama. “A better understanding of this behavior can inform decisions by people who are saving for retirement now.”
Stinson, along with co-authors and researchers Chelsea Rae Austin, Donna D. Bobek, and Marcus Doxey, developed an experiment designed to understand how participants spend money in a DT or CT account. They enlisted 350 participants, all of whom are U.S. adults over the age of 40, had filed at least five tax returns in the past seven years, and reported experience with common investment vehicles like individual retirement accounts (IRAs), 401(k)s, mutual funds, etc.
A key variable in the experiment included the amount of money participants had to work with. Researchers considered the behavioral aspect of paying taxes during retirement, noting that DT users had to endure the Prelec and Loewenstein mental accounting of savings and debt model when withdrawing from their funds. According to the research, the model “suggests individuals prefer to pay in advance, as they discount the ‘pain’ associated with a prepayment and can enjoy the benefit of consumption without the disutility of paying for the consumption concurrently.”
Even with equal starting balances among all participants, those in a DT account had to consider the taxes they would pay now, compared to those in a CT account who had already paid their taxes while working. Therefore, DT account users had less spending power than CT participants, the research noted.
“We gave the study participants options,” Stinson says. “And we found all participants spent money based on the perceived amount of money in their accounts. But DT users didn’t fully account for the percentage of the account balance that would be paid in taxes, even when we explicitly told them about the tax consequences.”
While the research shows that CT and DT users both spent money at the same rate when given equal starting balances, DT participants exhausted their savings faster since they were paying taxes in real-time. Therefore, the research suggests that DT users may have to save more overtime to allocate for future tax spending.
“People are spending money on the same things, so their expenses are the same,” says Doxey, who is also an associate professor of accounting at the University of Alabama. “However, DT users also pay tax on their savings every time they use them – which means, in practice, they’re paying an additional fee. As a result, their savings decline at a faster rate.”
Doxey adds: “Our findings suggest people with deferred accounts may need to save more than they think, unless they’re confident in their ability to account for taxes when making spending decisions in retirement.”
The findings also have important implications for financial advisors and policymakers alike, both whom may understand the tax effects of each account but do not understand how it impacts participant behavior. “Although policymakers have recognized that the plans have different tax revenue effects, they are likely unaware that tax timing differences also affect the quality of individuals’ decisions,” the research concludes.
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