NEW YORK (MainStreet) — If someone offered you the choice of $100,000 in a regular 401(k) or $100,000 in a Roth 401(k), which should you take? If you think it doesn’t matter, go to the back of the class. But don’t feel too bad. Most of the class will be back there with you.
The correct answer is that you should choose the Roth 401(k). That’s because taxes have already been paid on those funds, so you can withdraw them tax-free in retirement. Regular 401(k) contributions, of course, are made pre-tax. You don’t owe taxes now on money put into a regular 401(k), but you must pay taxes later when principal and gains are withdrawn.
“The balance may look the same when you see your statement, but in fact the Roth 401(k) balance represents greater savings in terms of what you can buy,” said John Beshears, a Harvard Business School researcher who recently co-authored a study examining how well people understand Roth 401(k) plans.
In the study, researchers asked people whose employers offered a retirement savings plan about the tax consequences of choosing a regular 401(k) versus a Roth 401(k). “Fewer than half -- 49% -- got the easiest question correct,” said Beshears.
Researchers also did before-and-after comparisons of employee contributions to both types of plans at companies that had recently introduced Roth 401(k) options. If employees understood the difference -- that Roth withdrawals are tax-free and therefore will go further in retirement -- they would contribute smaller amounts after-tax to the newly available Roth 401(k), Beshears said.
That’s not what researchers found. “In fact, we see very little difference,” Beshears said. “There’s a small difference, but not nearly the size of difference you’d expect if people really understood the different tax treatments.”
The bottom line is that a decade after Roth 401(k) plans came out, to most people they remain somewhat mysterious. “People by and large have difficulty understanding this,” Beshears says.
Yet experts say it is important for retirement savers to grasp the difference between pre-tax and after-tax retirement plans. Tim Estes, a Certified Financial Planner and investor coach in Fort Worth, agrees that few of his clients appreciate a Roth 401(k)'s value despite the fact that he considers it one of the most important retirement planning tools.
“My reasoning is that while you are working, you can afford to pay the taxes,” Estes says. “Once you retire, you have a finite amount of money. That money will last longer if you use the Roth 401(k) versus regular 401(k).”
Other studies have also shown low appreciation of Roth benefits. Human resources consulting firm Towers Watson found in a 2014 survey that, while more than half of employers offer Roth options, only 8% of highly compensated employees and 11% of non-highly compensated employees used Roths.
Few people understand the value of tax diversification, specifically how Roth plans protect against the risk of higher future tax rates, according to Marina Edwards, a senior retirement consultant with Towers Watson in Chicago. “Because we don’t know what the tax structure is going to be, we like to have some bucket of retirement dollars saved that we don’t owe taxes on,” Edwards said.
Edwards also said that employers are starting to auto-enroll workers in Roth savings plans. Under federal law, employer matching contributions go to pre-tax plans even when employees contribute to Roth plans. So employees who accept the default option are building in tax diversification by having the employer matching part of their retirement savings in pre-tax plans and the payroll deduction part in after-tax plans.
Younger workers can theoretically benefit most from Roth plans, because they are likely to have lower incomes and tax obligations than workers later in their careers. And according to Edwards, some of these fledgling careerists are beginning to come around to Roths. “The message is starting to slowly get out,” Edwards said.