Around the time of Woodstock and the team of Armstrong and Aldrin setting foot on the moon, a study was conducted on delayed gratification. The experimenter: Stanford professor Walter Mischel PhD. The subjects: 4-year old’s. The reward: Marshmallows.
To measure patience around delayed gratification, Mischel and his research team sat 4-year-olds at a table and placed a marshmallow in front of them. The child was offered a proposition: Eat that marshmallow now, or wait a tortuous 15 minutes, and be rewarded with a second marshmallow for their endurance.
Mischel’s, now famous Stanford Marshmallow Study, followed the children in two follow-up studies in the 80’s and 90’s over the next 30 years of their lives. Mischel found unexpected correlations between the results of the marshmallow test and the success of the children many years later, documenting that those children who could abstain from eating the first marshmallow earned higher SAT scores, achieved higher educational attainment, and maintained lower body masses.
“The child was offered a proposition: Eat that marshmallow now, or wait a tortuous 15 minutes, and be rewarded with a second marshmallow for their endurance.”
Turns out, patience- and by extension, delayed gratification- is a virtue.
Similarly, the ability to postpone immediate gratification, and instead chose to invest savings for one’s future contributes to an individual’s ultimate financial freedom and greater options in life. Despite this, US tax laws have incentivized Americans to save by giving them an immediate tax deduction now by contributing to a 401k or IRA, only to have to repay those same tax savings back later when they retire. Kind of like: We will give you a marshmallow now, but you have to give it back to us later.
In 1997, the Roth IRA was born. The Roth option didn’t entice taxpayers with an upfront tax deduction, but provided an offsetting reward that the taxpayer never had to pay any tax on the withdrawals. The Roth IRA was like a Cayman Island bank account, free from the eyes of the IRS.
Originally, the drawback to a Roth IRA was that the accounts were limited only to taxpayers with moderate incomes. Then, in 2006, Congress expanded the Roth mechanism to 401k’s plans, and by doing so opened up the Roth tax benefits to taxpayers in all brackets.
Reducing the traditional 401K and IRA versus the Roth decision to its simplest form: If you think your tax bracket might be lower in retirement, take the upfront tax deduction offered by the traditional 401k and IRA today, and pay back the taxes in a lower tax bracket in retirement. If you think your tax bracket might be higher in retirement (or government budget deficits will increase future tax brackets) opt for the Roth now, and be rewarded with a lifetime pass from future higher tax rates.
As a CPA, I would have thought that there would have been a greater mass migration to Roth 401k’s, Roth 403b’s, and Roth Deferred Comp plans. There wasn’t. While these Roth pension savings vehicles may not be for everyone, there are three factors I believe blind investors to their benefits:
Cash Flow: For an employee in a 33% tax bracket, a $1,000 contribution to a traditional 401k plan results in an immediate $333 larger paycheck. Or worded differently: A $1,000 traditional contribution only costs an employee $667 after tax savings. On the other hand a $1,000 Roth 401k contribution costs $1,000. Postponing the marshmallow-sugar high tax savings of $333 requires more patience, calculation, and delayed gratification.
Wealth Effect: Let’s say in the prior example’s tax brackets, a husband contributes $1,000 to a traditional 401k, which really only costs a net amount of $667. His wife, working for the same company, can only afford to save the same $667 net amount, but opts for a Roth 401k. After many years in the exact same investments, the husband’s account grows to a value of $1,000,000 while his wife’s only grows to $667,000. While the husband feels like his account is more substantial, the reality is that both the husband and wife have the same net values in their accounts. The husband has an eventual $333,000 tax lien to pay back taxes, whereas his wife does not. Thus, the traditional 401k can create an illusion of wealth. Or, it can create a false mental comparison of the $1 million 401k value being equivalent to a million dollar house or even a million dollar Roth 401k account. It is not!
Partial Financial Advisors: Because a financial advisor, brokerage firm, or 401k administrator are often compensated on a percentage of an account size, they receive more income and have a beneficial interest in promoting the husband’s $1 million investment in a traditional 401k than the wife’s $667,000 in a Roth 401k- even though, after taxes, they are both equal in value.
Consult with your tax advisor about whether a Roth 401k, Roth 403b, or Roth deferred compensation account is best for your particular financial situation.
Investing is often framed by professionals seeking your business to be more complex than it actually is. Too many bells and whistles often mask inferior products. Remember that the attractiveness of the salesperson is often inversely correlated to the quality of their product. But we have a new paradigm: Invest and tax plan like a four-year old waiting for your second marshmallow.
Deferred Comp Update:
In answer to many of your questions about my recent articles, now 100 days later and counting, the San Francisco Employees’ Retirement System’s (SFERS) CEO still has not answered my questions.
At the February 8, 2017 Retirement Board meeting (two hours and 46 minutes into the meeting when it was proposed that an audit of SFERS $2.8 billion deferred comp account would only cost each of the 30,0000 D.C. Plan participants $1, the Chairman Comp Committee, firefighter Joe Driscoll vehemently objected. Joe asserted he wanted to protect City employees from the $1 per person cost of an audit. That’s ironic, because Joe said nothing in 2009, when SFERS’ deferred comp plan investors lost $4,000 on average due to failed investments in derivatives. Save a dollar, but lose four thousand of them? No big deal. Way to set your priorities, Joe.
Lou Barberini, CPA lives in San Francisco’s West Portal neighborhood. Feedback: [email protected]