Roth versus traditional accounts in a life-cycle model with tax risk

Abstract

Link to this article: http://journals.cambridge.org/abstract_S1474747212000054 How to cite this article: MARIE-EVE LACHANCE (2013). Roth versus traditional accounts in a life-cycle model with tax risk. AbstractThis paper analytically solves a life-cycle model that compares traditional and Roth retirement accounts. It includes realistic features such as tax deductibility of contributions and taxation of withdrawals, tax bracket structure with deductions, taxation of Social Security benefits, and tax risk at retirement. With current taxes, choosing a traditional account over a Roth creates small welfare losses in only a few cases, largely for those with higher incomes and pensions who are subject to the taxation of Social Security benefits. We also investigate tax variability and find that diversified strategies offer only small risk reduction benefits in our illustrations.

Seeking tax alpha in retirement income

“…Many authors also used life-cycle models that focus on both the accumulation and decumulation phases. Lachance (2013) solves a life-cycle model for both the accumulation and decumulation phases using tax-deferred and tax-exempt accounts. They find that choosing a tax-deferred over a tax-exempt account creates a reduction in wealth, most noticeable for those with higher incomes and pensions, which increases social security taxation.…”

Very Last Thoughts

“…But, for those readers who are interested in pursuing and/or reading more about this embryonic area of research, namely the overlap of retirement income optimization and tax uncertainty, see the articles cited as [ 4 , 8 , 14 ] and [ 12 ] and the references therein.…”

How would 401(k) ‘Rothification’ alter saving, retirement security, and inequality?

“…A simulation study by OECD (2018) provided a theoretical analysis of the EET versus TEE approach; nevertheless, the metric used by the OECD to compare the two tax regimesthe overall lifetime tax advantagedid not incorporate household behavioral responses to changes in tax incentives. Lachance (2013) compared investor decisions between a traditional tax-qualified retirement account versus a Roth account, but she did not incorporate Social Security claiming behavior, endogenous work hours, risky labor income, or market return risk, as we do here. Brown et al (2017aBrown et al ( , 2017b found that there is some uncertainty in future income tax rates, so Roth accounts could be an important vehicle to mitigate the risk resulting uncertainty over future tax schedules.…”