A couple of years ago, the University of Arizona added an option to its retirement plan. Instead of contributing pretax money, which is the traditional option for 401(k), 403(b), and other workplace plans, workers could contribute aftertax money to a Roth account.
Employees weren’t sure what to do. Among them was Scott Cederburg—and he's a professor of finance.
Researching the question didn’t help much, despite his expertise. “There weren’t really good, solid answers,” said Cederburg, who teaches at the university’s Eller College of Management.
Ever since Congress created Roth accounts , savers have faced this quandary: Roth or traditional? The experts’ advice is often vague, noncommittal, or downright contradictory. In other words, “it depends.”
It depends, for example, on what tax rate you’re paying now, compared to what tax bracket you’ll be in when you retire. Traditional 401(k)s, along with traditional individual retirement accounts, lower your taxes now, but you end paying at the other end, when you take the money out in retirement. With a Roth account, you pay taxes now, but all withdrawals later, including investment gains, are tax-free.
It’s pretty clear, then, that Roth accounts should work well for young, low-paid workers, who are probably paying the lowest tax rates of their careers. And a recent study suggested that workers may end up unintentionally contributing more to Roth 401(k) accounts than to traditional 401(k)s, albeit unintentionally.
The benefits of a Roth are less obvious for older or wealthier workers, who are paying high tax rates now and don’t know what their taxes will look like in 20 or 30 years. How do they balance lowering their tax rate now, using a traditional account, with the advantages of a Roth’s tax-free pool of money in retirement?
Cederburg decided to find out. A new study, which he conducted with two other finance professors—David C. Brown of the University of Arizona and Michael O’Doherty of the University of Missouri—used software to simulate the optimal saving strategies for a million retirement scenarios over the next 30 years.
Their conclusion: Most investors, including wealthy ones, end up better off with a mix of assets in traditional and Roth accounts.
Each kind of account has advantages, the study found. Traditional 401(k)s and IRAs can be used strategically to lower your current tax rate, which is especially valuable when a traditional contribution bumps you down to a lower tax bracket. Roth accounts insure against the chance that tax rates will spike as baby boomers retire, health-care costs rise, or the nation faces a more serious fiscal crisis.