Participants Do Not Factor Tax Rates Into Retirement Savings Decisions

Researchers for the Center for Retirement Research (CRR) at Boston College examined individual choices between Roth and pre-tax deferrals to retirement plans.

The results of their experiments suggest that individuals may not systematically rely on their beliefs regarding their relative tax rates when making plan choices, but that at least part of that failure is due to a lack of awareness and/or understanding. However, the researchers say, although education increased participants’ use of expected tax-rate changes in their plan choices, participants continued to display an economically “irrational” preference for pre-tax deferrals. 

The researchers found this to be systematically related to participants’ more general non-economic attitudes and preferences and the relation of these attitudes and preferences to the features of the plans being evaluated. However, they did find that investment risk preference is negatively associated with a preference for pre-tax deferrals and may be influenced by tax-related contextual variables as well.

“Consistent with prior research, our results suggest that individuals, on average, do not respond rationally to the relative economic incentives associated with alternatively structured plans. Further, although errors can be reduced with increased awareness, our evidence illustrates that individuals systematically incorporate non-economic factors into their retirement plan choices, often leading to a preference for [pre-tax deferrals] even when such a choice is economically adverse,” the researchers say in their report.

Even when participants were educated about how their tax rates before and after retirement related to their retirement income, 49% who reported that they expected their tax rates to be lower in retirement nonetheless elected to make their contributions to on a pre-tax basis. Conversely, only 18% of those who reported that they expected their tax rates to be higher in retirement nonetheless selected to make their immediate contributions as a Roth deferral.

The research found that participants, on average, prefer to pre-pay for consumption and positively discount future payments. As the researchers expected, they link the tax costs and savings of Roth deferrals more than they do pre-tax deferrals and see the tax costs and savings of Roth deferrals as more uncertain than those of a pre-tax deferrals.

One other finding of the research is that a sense of urgency regarding saving for retirement is positively associated with savings rates. “While this is not surprising in itself, the current crisis in retirement preparedness suggests that current marketing and education campaigns are not sufficiently stoking investors’ sense of urgency,” the researchers said. “Further research into the factors that increase a sense of urgency for retirement saving could be fruitful for future campaigns aimed at increasing savings rates.”