While a rose by any other name may smell as sweet, Shakespeare’s famous maxim does not hold up when talking about tax-sheltered savings plans. Our new research finds that people are more likely to choose a plan that has the words “tax-free” in the title, regardless of the details in fine print.
Canada has two main tax-sheltered savings plans that encourage people to put money away for retirement and other expenses. Since being introduced in 2009, the tax-free savings account (TFSA) has become far more popular than the registered retirement savings plan (RRSP).
In our paper in the Canadian Tax Journal, we show that preference for TFSAs may be due, in part, to a psychological bias for the phrase “tax-free.”
These two words are used as a mental shortcut — a heuristic — that individuals sometimes rely on when choosing a tax-sheltered savings plan. People often use these heuristic cues when navigating complex situations because the alternative — a process known as “systematic processing” — requires more careful scrutiny and effort.
If the information being considered is either overwhelmingly ambiguous or extensive, heuristic cues often win out, which suppresses systematic processing. This suppression of systematic processing can lead individuals to make sub-optimal financial decisions, as they might overlook critical details and benefits of alternative savings plans.
Tax-deferred vs. tax-pre-paid
The Canadian government introduced the RRSP in 1957 to encourage people to save for their retirement. It can be described as a tax-deferred account because contributions receive a tax deduction, whereas withdrawals are taxed.
The TFSA can be described as a tax-prepaid account because contributions are made with after-tax amounts and withdrawals are not taxed. Investment income is not taxed in either plan, which means that interest earned is tax-free for both the TFSA and RRSP.
An optimal financial strategy would use both of these tax-sheltered savings plans. The TFSA is ideal for most people for short-term savings, while the RRSP usually makes sense for long-term savings. This is because RRSP contributions are tax deductible at a person’s current tax rate, and taxes can be paid at withdrawal, which is usually at a much lower tax rate if the person is retired.
But the TFSA has out-paced the RRSP in what is known as the “crowding-out effect.” In fact, since 2013, total TFSA contributions have far surpassed total RRSP contributions. Canadians’ savings in TFSAs, while fiscally wise, may come at the expense of longer-term savings if people forego the RRSP.
Favouring the favourable heuristic cue
Canada, the United Kingdom and the United States are the only countries with both tax-deferred and tax-prepaid plans. However, Canada is the sole country of the three with a favourable heuristic cue in one of the titles.
This provided a natural laboratory for us to test the hypothesis that, all else being equal, people are more likely to choose a plan with the phrase “tax-free” in its name.
To test this hypothesis, we conducted three social psychology experiments where we asked participants to choose between a “tax-free account” or a “retirement savings account.” In total, we recruited 1,132 participants from Canada and 184 from the U.K.
Different groups of participants had the names paired with brief or longer descriptions that were either accurate or inaccurate. This allowed participants to engage in either heuristic or systematic processing, or both simultaneously.
When the savings plan name included “tax-free,” significantly more participants chose that plan compared to the alternative, regardless of what the plan description said. Whether the plan offered short-term or long-term savings, people generally chose the option with “tax-free” in its name.
In all three experiments, participants used the heuristic to guide their choice, rather than scrutinize the plan information.
Individual and systemic implications
Our research provides new and robust evidence on how decisions on tax-sheltered savings plans may be biased because of a tax-aversion heuristic. This bias may have both individual and broader implications.
An individual’s decision about saving money can have long-term implications for their retirement and personal financial situation. From an economic perspective, decisions about how your savings will reduce total taxes paid over your lifetime should be based on current and predicted future marginal tax rates, not heuristics.
Substituting short- to intermediate-term savings in TFSAs for long-term savings in RRSPs may increase Canadians’ financial insecurity in retirement and ultimately increase their reliance on public pensions and other government assistance.
On a broader scale, this bias for a “tax-free” plan could impede the government from achieving its tax policy objectives. If people disproportionately choose short-term savings because of the appealing “tax-free” heuristic in the TFSA name, and forego long-term savings because the RRSP lacks this heuristic cue, these folks may actually end up paying more in taxes. This is because, RRSP contributions are tax-deductible, whereas TFSA contributions are not.
Although financial education and advice may help individuals maximize their economic potential, our research shows that providing more information about a tax-sheltered savings plan may not overcome a heuristic bias.
The sweet allure of “tax-free” in a title suggests governments should avoid choosing names for tax-sheltered savings plans that contain a heuristic cue, whether it be favourable or unfavourable.
Ruth Pogacar receives funding from the Social Sciences and Humanities Research Council of Canada.
Jonathan Farrar receives funding from the Social Sciences and Humanities Research Council of Canada.
Leslie Berger receives funding from the Social Sciences and Humanities Research Council of Canada.
Lu Zhang receives funding from the Social Sciences and Humanities Research Council of Canada.
This article was originally published on The Conversation. Read the original article.
