Traditional or Roth?
Your personality can make a difference when choosing a Roth or traditional IRA or 401(k).
When you think about making a financial decision, you might imagine poring over a spreadsheet or crunching numbers on a calculator. But you might be better off with a mirror than an abacus. That’s because making smart choices about money requires more than just math: Understanding your “financial personality” can go a long way toward helping you make better decisions. Are you a big spender or a dedicated saver? Do you use up all your disposable income or do you always manage to put something away for a rainy day? Your answers could make some ways of saving for retirement far more effective for you than others.
What shapes your financial personality? For most people, spending, saving, and investing have as much do do with emotion as math. Money is a very personal topic. Some people manage their finances like a tight ship. These highly motivated savers tend to be very organized, disciplined, and methodical about their finances and are generally better about putting money away. One reason is they have good “future time perspective,” which helps them see the value of waiting for something rather than insisting on immediate gratification. But for everyone who approaches money with this kind of rigor, there are plenty of other folks out there who are more impulsive, place a greater value on enjoying their money in the here and now, or struggle to stick to their budget.
To see how financial personality can dictate better ways to save, take a look at the following case study. Using hypothetical investors, this study illustrates how some personality factors may determine whether it’s better to save in a Roth (after-tax) or traditional IRA, 401(k), or 403(b) (pretax).
Personal implications: Roth or traditional?
Conventional wisdom tells you to consider your tax rate today and in retirement to help determine whether making Roth or traditional pretax contributions to a 401(k) or IRA would make more sense. But tax rates don’t tell the whole story; personality could also be a consideration. Your propensity to spend or save your disposable income could also play a role in which type of account may better help you prepare for retirement.
Here’s why: Generally, contributions to a traditional IRA, 401(k), or other workplace savings account can help lower your taxable income if certain requirements are met. But any money you save on taxes can help you improve your retirement readiness only if you’re disciplined enough to put your tax savings back into your retirement plan. If you get a refund and go out and spend it, it’s not going to help you be ready for retirement.
With Roth contributions—to an IRA or 401(k)—you have to pay taxes on your contributions up front. That takes away from your disposable income. With a Roth 401(k) your contributions and your taxes are coming out of your paycheck each pay period. With a Roth IRA, your contributions come from after-tax savings. But, if you’re like most people, who tend to spend what they earn anyway, having less disposable income might be a good thing when it comes to your retirement savings. You’ve already paid your taxes, so you get to take your money out tax free,1 which could leave you more to spend in retirement. In a sense, says Kenigsberg, “a Roth 401(k) forces you to save more for later by keeping less in your pocket now.”
To see how this scenario might actually play out in terms of numbers—and potentially increased savings—consider three hypothetical investors, Brian, Sara, and Jeff, who all have certain things in common:
Age: 45
Plan to retire at: 65
Gross household income (both spouses' salaries): $125,000
Marginal tax rate: 28%*
Expected marginal income tax rate in retirement: 28%
Hypothetical pretax return on investments: 7%
Hypothetical after-tax return on investments: 6%
But, they each have very different financial personalities.
Brian is very frugal and an extremely disciplined saver who contributes to a traditional pretax 401(k). He tracks every penny, and if he finds himself with some money he hasn’t budgeted at the end of the month, he invests all of it. Same goes for tax returns, bonuses, and any windfalls. That’s admirable, but probably a little unusual.
Sara, like a lot of people, tends to spend whatever she has left in her paycheck, so while she too contributes to a pretax 401(k), when she gets a tax refund or has money left over at the end of the month, she doesn’t save a penny. Instead, she uses it to pay for a much-needed vacation or a night on the town.
Jeff has a lot in common with Sara; he knows he’ll spend money if he’s got it. So he saves through a Roth 401(k) instead and gets his income tax payments out of the way now, hoping to have more income available in retirement.
Let’s assume they each invest $5,000 in their 401(k) when they are 45 years old and won’t need the money until 10 years after they retire, when they are age 75. That’s a 30-year time horizon. Let’s also assume that Brian and Sara each receive a $1,400 tax refund as a direct result of their 401(k) contributions, while Jeff doesn’t receive a refund because his Roth IRA contribution doesn’t reduce his taxable income. How much would they each have after 30 years, based on the type of 401(k) account they chose, and whether they saved or spent their tax refund? Take a look:
As you can see, Sara ends up with the least amount of savings since she chose the pretax 401(k) but spent her entire refund. Her account grows just like Jeff’s, at 7% annually, but she then has to pay more than $10,657 (or 28%) in taxes as she withdraws the money in retirement. Brian does much better than Sara: After paying taxes in retirement, he ends up with the same $27,404 from his 401(k) that she does, but he also invests his refund in a taxable brokerage account. In this example we assume Brian’s taxable account will have grown at 6% annually. Why the lower rate? Because as Brian invests, he may have to pay taxes. For this example, we are estimating those taxes will reduce his investing performance from 7% to 6%. At 6%, Brian will have $8,041 in his taxable account, so he’ll have a total of $35,445. Jeff does even better than Brian—the $5,000 in his Roth 401(k) has also grown at 7% annually, to $38,061, and he doesn’t have to pay any tax on withdrawal.
In effect, the Roth 401(k) gave Jeff two big advantages that account for the difference: First, the Roth captured all of Jeff's tax savings in the plan—safe from his temptation to spend it before retirement. And second, all of Jeff’s assets were in the retirement account enjoying the highest rate of return in this hypothetical example. Of course, Sarah could make up the difference by boosting her contributions—but only if she were not prevented from doing so by contribution limits, and only if she took the time to figure out how much to increase her contributions. For Sara, increasing her contributions from $5,000 to $6,944 would leave her with the same balance as Jeff.
This example shows that a Roth 401(k) might actually be an easier way to realize your savings goals by 1) making you pay your income taxes at the same time you contribute, 2) limiting the disposable income available for you to spend, and 3) allowing you receive tax-free distributions and potentially make a higher return on your investments. And, given that most people tend to spend what they earn, having less in your pocket now leads to more in your pocket during retirement.
Clearly, many factors determine what might be the best way for you to save for retirement—from what you can afford to your risk tolerance and tax situation. You might not typically think beyond numbers and facts to make saving decisions, but, given this illustration, maybe you should. Personality can play a role in how effectively you save for the future. Not just in terms of whether or not you save, but more importantly how you do it. And that gives a whole new meaning to the idea of “personal” finance.
To discuss retirement savings or just where to begin on your path to financial freedom, contact A.D. Financial Planning.
1. A distribution from a Roth IRA is tax free and penalty free provided that the five-year aging requirement has been satisfied and one of the following conditions is met: age 59½, death, disability, qualified first-time home purchase.
*Assumed tax rate.
References: What's your savings style? (2011). Retrieved April 20, 2012, from https://www.fidelity.com/viewpoints/traditional-or-roth