Workers might be saving money for retirement in either a traditional tax-deductible 401(k) or in a Roth 401(k), but they might not understand the differences between the two, so they’re not making an informed decision on which to use or how much to save in each.
That’s according to research from the National Bureau of Economic Research, which looked at the employee contributions at 11 large companies that added a Roth 401(k) option after 2006. The NBER study revealed that there was no significant difference in total contribution rates between those employees hired in the year before the Roth was added and those who were hired immediately afterward.
While a contribution of $1,000 will cost the employee less in take-home pay when going into a traditional 401(k), it will cost the whole $1,000 when going into a Roth, since the money going into a Roth is taxed up front — while withdrawals, including investment returns, are not taxed on withdrawal. But employees either don’t realize that the Roth funds won’t be taxed when they withdraw them on retirement, or are too much in need of the current tax break to wait that long.
The reason the study concluded that people don’t really understand the difference is that contributors could have gotten away with putting less money into a Roth, since because of the tax-free withdrawals at retirement they’d get the same amount of money out that they would have if they’d contributed more money into a traditional plan.
But, said the study, “that’s not what they do.”