The Impact of Cognitive Ability on Roth IRA Ownership

Abstract:     
Achieving policy objectives through the tax code may be compromised by the complexity of tax minimization strategies. To take advantage of favorable tax policy, consumers must understand the tax code and the potential benefits. Calculating the financial benefits of a tax policy can be difficult, especially when comparing tax-deferral strategies because the benefits will not be realized immediately. Roth IRAs provide a prime example of a deferred tax minimization tool because the tax benefits of a Roth IRA are not realized until retirement. This study analyzes the impact that cognitive ability has on the adoption of favorable tax strategies by following the adoption of the Roth IRA after its creation. Using data from the 2004 and 2008 administrations of the National Longitudinal Survey of Youth (NLSY), we hypothesize that higher cognitive ability is positively related to owning a Roth IRA and to early Roth IRA adoption. Consistent with our hypothesis, we find that cognitive ability is positively related to Roth IRA ownership and early adoption, even when controlling for education, income, and net worth. Individuals with higher cognitive ability are better able to legally minimize their tax liability, thereby maximizing household utility. If households with higher cognitive ability are better able to recognize and implement beneficial changes in the tax code, then tax policy will yield unintended distributional consequences. The complexity of tax minimization strategies also limits the ability of policy to modify household behavior in the ways envisioned by policymakers.

Number of Pages in PDF File: 21

Keywords: cognitive ability, Roth IRA, National Longitudinal Survey of Youth (NLSY)

JEL Classification: D14, D83, H24

working papers series