Taxpayers' Preference on Retirement Plans May Mean More Education

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As accountants, enrolled agents and tax preparers increasingly expand into tax and wealth planning services, a new study reveals that taxpayers favor back-loaded plans, such as Roth IRAs, to traditional, front-loaded ones – even though they may not completely understand the tax issues.

But that lack of understanding could open the door for the need in more extensive planning education.

“The Relative Effects Of Economic And Non-Economic Factors On Taxpayers’ Preferences Between Front-Loaded And Back-Loaded Retirement Savings Plans” from the Center for Retirement Research at Boston College also finds that, even though taxpayers favor Roth IRAs, they invest more in their traditional IRAs —  which is due to taxpayers lacking awareness or understanding of how their tax rates will affect their IRA choices.

“We find mixed evidence regarding whether individuals appropriately weight expected tax rate changes in their plan choices, despite the fact that these tax rate changes are the primary factor driving the relative after-tax returns of front- and back-loaded plans,” the study finds. “Conversely, we find evidence that plan attributes related to individuals’ non-economic attitudes and preferences consistently influence plan choice.”

For tax professionals trying to decipher what clients may want or need, the study offers three points to consider:

  • The potential effectiveness of alternative savings incentives or taxpayers’ investment choices should not be considered based only on their financial impact.
  • Taxpayers generally don’t respond rationally to the economic incentives of alternatively structured plans. Tax guidance can help reduce errors, but taxpayers “systematically” incorporate noneconomic factors in making retirement plan choices. That often leads to a preference for Roth IRAs even when it doesn’t make economic sense.
  • Statistical data have shown that 70.6 percent of taxpayers use traditional IRAs the majority of the time, compared to 23.1 percent who favor Roths. Why is there a discrepancy between a preference for Roths while investing more in traditional IRAs? The study finds that may be the result of “artificial barriers” to participating in Roths, which could include income limits and what employers offer.

The findings are key because pension plans are disappearing or being frozen, which makes personal retirement savings even more important.

And, while legislators have provided several types of savings incentives through tax law, studies indicate that taxpayers don’t have enough retirement money because of their investment decisions and inadequate savings.

Through a series of experiments, the study’s authors found that even when traditional and Roth IRAs were both available, judgments and preferences based on objective, public information can be misleading if taxpayers are driven by subjective beliefs or certain unobservable issues.

Yet, when taxpayers were given tutorials about the economic effect of their choice or they were randomly assigned to tax rate change conditions, tax rate changes had a big impact. 

But when they received no education about plans or tax rate changes, tax rates had no impact.

The study’s authors were Andrew Cuccia, associate professor and a Grant Thornton faculty fellow at the University of Oklahoma; and Marcus Doxey and Shane Stinson, assistant professors at the University of Alabama.

The Social Security Administration (SSA) provided a grant to fund the research. The study’s findings were not influenced by the SSA, any federal agency or the universities.

“Our findings should be of interest to policymakers interested in using the tax system to encourage saving,” according to the study. “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.”

About Terry Sheridan

Terry Sheridan

Terry Sheridan is an award-winning journalist who has covered real estate, mortgage finance, health care, insurance, personal finance, and accounting and taxation issues for newspapers, magazines, and websites. A Chicago native and former South Florida resident, she now lives in New England.

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