Researchers from the University of Arizona and the University of Missouri at Columbia note in a report that an uncertain, progressive tax schedule is the norm in the American economy.
With this in mind, they investigated the optimal savings decisions for investors with access to pre-tax (traditional) and post-tax (Roth) versions of tax-advantaged retirement accounts, using a model that features a progressive tax schedule and uncertainty over future tax rates. While traditional accounts are valuable for hedging retirement account performance and managing current income near tax bracket cutoffs, Roth accounts allow investors to mitigate uncertainty over the future tax schedule. They conclude that the optimal asset location policy for most retirement savers involves diversifying between traditional and Roth vehicles, and, contrary to conventional advice, the largest economic benefits from Roth investments accrue to high-income investors.
In the absence of tax-schedule uncertainty, Roth investments are primarily attractive for investors with low current income relative to expected future income as a means to lock in low tax rates, the researchers say. However, introducing additional tax uncertainty increases the variability of investors’ future consumption, and Roth accounts eliminate a portion of this risk for investors regardless of current income.
Tax-schedule uncertainty is of great economic importance for the wealthiest investors, the research finds. For these investors, the annual fee to account for tax uncertainty reaches 0.68% for investors with 10-year time horizons and 2.10% for investors with 30-year horizons. Fees for investors with relatively low current incomes are small since these investors tend to utilize Roth accounts whether or not they face tax-schedule uncertainty. However, investors with higher current incomes focus primarily on pre-tax investments to avoid taxes now, while ignoring tax-schedule uncertainty. “These results stand in direct contrast to popular investment advice that instructs wealthy investors to avoid Roth accounts. Our analysis shows that for these investors, tax-strategy diversification is particularly attractive, despite their high current marginal tax rates,” the researchers wrote in their report.
The researchers note that Roth account usage is low among participants who are offered this option. They feel this may be due to a lack of education.
“Our results are of practical importance to employers and regulators who determine the retirement savings options available to employees. In particular, broadening access to Roth versions of workplace accounts would provide investors with important tools for managing their exposures to tax risk,” the researchers conclude.
The research report may be downloaded from here.