The math behind saving for retirement can be tricky, but so are the rules tied to investment accounts. If savers had a bit more context around the different types of savings vehicles, they might be better equipped to do so, a new study found.
Researchers from HEC Montreal, a business school in Canada, analyzed individuals’ knowledge of and approach to using two types of retirement saving accounts—“backloaded,” which are like traditional individual retirement accounts or 401(k) plans in the U.S. and thus are invested with pretax dollars that are taxed upon withdrawal, and “front-loaded” account, similar to a Roth IRA, which is funded with after-tax dollars and then withdrawn tax-free. They found in some scenarios individuals picked which to use “as if they had flipped a coin.”
See: What kind of retirement saver are you?
Participants were questioned on which account would be best in various scenarios. When some of the participants were given context, such as what these accounts did and how they’re taxed, they noticed individuals made better decisions and avoided mistakes. The researchers found offering more information about these accounts improved their scores by 6% to 15% in some cases. Their assistance also lifted the after-tax lifetime-income average benefit for participants up to $1,900 per scenario they tested.
Researchers noted previous studies on backloaded and front-loaded accounts. They cited reports that found low-income workers are more likely to use traditional accounts when available, and that users of front-loaded vehicles, like Roth accounts, are likely to be more financially knowledgeable than those who use the alternative.
Americans often have a hard time understanding all of the terms, rules and eligibility requirements of retirement investment accounts. Only about one in five Americans know how much they’re allowed to contribute to a 401(k) plan and a little more than 25% of nonworking spouses contribute to an IRA (which are usually intended for working individuals, with exceptions for nonworking spouses). Lack of financial literacy can deter people from saving for their retirement, or doing so properly.
Also see: Why new tax rules make Roth accounts better than ever
There’s no one answer for which type of account to use. There are many factors to consider when making a decision, including an individual’s current and future income-tax rates and how much they’re able to save. The general rule is, if your tax rate is high now and you expect it to be much lower in retirement, you should defer paying those taxes, whereas if your income is at its lowest now, you pay the taxes upfront so that the savings can be withdrawn “tax-free.”
A single individual earning between $39,476 and $84,200 is in the 22% federal tax bracket in 2019, and in the 12% tax bracket if he earned between $9,701 and $39,475. Assume this individual was 35 years away from retirement and wanted to invest in an IRA, with a moderately conservative long-term rate of return at 5%. If that person earned more now than in retirement (say he was in the 22% tax bracket now, and in the 12% tax bracket at his first IRA withdrawal), he’d see slightly more money in a traditional IRA than a Roth ($32,585 versus $31,520, respectively). But, if he was in the 12% bracket now and in the 22% bracket at his first withdrawal, he’d probably want to invest in a Roth IRA, which would be valued at about $31,520 compared with a traditional IRA, which would have a value of around $27,698.