Choosing the right savings account could be a decision worth over $US100,000.
A new Harvard study set to publish in July sheds light on the benefits of the Roth 401(k), a retirement savings account that allows employees to set aside the annual maximum (up to $US18,000 in 2017) on an after-tax basis, resulting in tax-free withdrawals during retirement.
Contributions to traditional 401(k)s, which have been the default employer-sponsored retirement account in past years, are tax-deferred, meaning you do not pay taxes on the amount until you make withdrawals in retirement.
Not all companies offer a Roth 401(k), but according to a recent report from Vanguard, the option is on the rise. Nearly two-thirds of Vanguard 401(k) plans include the Roth feature, up from 49% in 2012. Among employees who have access to it, 13% elect to use it.
When it is available, all employees, regardless of income, have the ability to contribute to a Roth 401(k). That’s in contrast to the popular Roth IRA, which excludes high earners from contributing directly to an account. Matching contributions are still made on a pre-tax basis, however, even if your own contributions are directed to a Roth 401(k).
John Beshears, the lead author of the Harvard study and a behavioural economist and assistant professor of business administration at Harvard Business School, recently spoke to the Wall Street Journal
about the study’s findings.
“What we found is that people didn’t save any differently, in the sense that they still had the same total contribution rate. But with the Roth 401(k), that actually translates into more purchasing power in retirement,” Beshears told the Wall Street Journal.
He went on to explain:
“If a worker saves $US5,000 a year in a 401(k) for 40 years and earns 5% return a year, the final balance will be more than $US600,000. If the 401(k) is a Roth, the full balance is available for retirement spending. If the 401(k) is a traditional one, taxes are due on the balance. Let’s say the person’s tax rate is 20% in retirement. That makes for a difference of $US120,000 in spending power, which a life annuity will translate into about $US700 a month in extra spending.”
Whether a Roth 401(k) is better than a traditional 401(k) depends on your personal situation. However, if you’re following a general rule of thumb, such as saving 10% of your income for retirement, Beshears said those who use a Roth 401(k) will end up with more money in retirement.
“We’re not recommending the Roth 401(k) necessarily, but it does seem conducive to increased savings,” he said.