How is Your 401(k) Plan Like a Marshmallow?
No, I’m not crazy. It’s all about the battle between instant gratification and postponing gratification.
There was a classic psychological study done in the early 1960’s at Stanford University that became known as ‘the marshmallow test”. Young children were given the option of eating one marshmallow right now or getting two marshmallows in a few minutes.
To make it more interesting, the children were alone in a room with two plates, one with one marshmallow and the other plate had two.
What would they do?
Overwhelmingly they chose the one right now!
No postponement of gratification for them!
This preference of instant gratification appears to carry through when employees are given the choice of contributing to a traditional pre-tax 401(k) option or a Roth 401(k) option where they are contributing after-tax dollars.
The delayed gratification of future tax-free dollars coming out of the Roth 401(k) just doesn’t seem to be very enticing.
While over 70% of 401(k) plans offer a Roth contribution option, less than 7% of employees take advantage of it.
They’re getting the instant gratification of pre-tax contributions – those dollars do not count as taxable income to the employee for this year.
In our opinion, this is potentially a big mistake.
While it’s not right for everyone, for most, especially younger employees, it’s going to make a huge difference later on.
Let me explain why it’s so important.
First of all, the dollars coming out at retirement will be totally TAX-FREE from a Roth 401(k) or Roth IRA. Totally! No more retirement partnership with Uncle Sam.
Secondly, you will not have to take Required Minimum Distributions (RMDs) at age 70 ½ if you’re taking dollars from a Roth 401(k) or Roth IRA. You already paid the tax on them in the beginning, so not now. You get to keep everything that’s being withdrawn.
And lastly, money taken out of a traditional pre-tax 401(K) or IRA will count as taxable income and will count toward the probability of making most of your Social Security benefit payments taxable to you. This comes as a big surprise to a lot of people.
Both of our millennial daughters are using their Roth 401(k) options after being coached by their dad. And it’s important to remember that the company match is still going to happen and it’s going to go into the pre-tax portion of their account.
So, at retirement, assuming nothing changes in how they contribute going forward, they will be receiving taxable dollars from the match portion and tax-free dollars from their contributions.
This is a simple example of diversifying their future income streams between taxable and tax-free.
Let’s rethink the issues around instant gratification. It’s OK to get your online order through Amazon Prime within hours or a day, but it’s not the same with getting a pre-tax 401(k) contribution today only to have to pay more in taxes later on.
Let me ask you, which would you prefer, taxable or tax-free? It’s not a trick question.