Pre-Tax vs. Roth Contributions: What’s Best for You?

By David Amiot, CFP®, CRPC® | Jun 27, 2022 |

Individual Retirement Accounts (IRAs) and many company-sponsored retirement plans allow you the option to make a tax-advantaged contribution: either pre-tax (traditional) or after-tax (Roth) contribution. What’s the difference?

If you are saving for retirement through an IRA or tax-advantaged retirement plan set up by your employer, you may have questions about the type of retirement plan your employer offers.  And the allowable contribution options you have to choose from. 

The type of retirement account your company offers is based on the organization type: 401(k) plans and  403(b) plans. 

What are 401(K) plans?

A 401(k) plan is an employer-sponsored retirement savings plan in the United States. It allows employees to save and invest a portion of their salaries before taxes are taken out. Often, employers will match a certain percentage of an employee’s contributions up to a certain limit, which can provide a significant incentive for employees to participate. The funds in a 401(k) plan can be invested in various financial instruments, such as stocks, bonds, and mutual funds, allowing for potential growth over time. 401(k) plans are for for-profit companies 

What are 403(b) plans?

A 403(b) plan is a type of retirement plan available to certain employees of public schools, tax-exempt organizations, and some ministers in the United States. Like a 401(k) plan, employees can contribute a portion of their salary to the plan, often with the benefit of tax-deferred growth on earnings until withdrawal. Employers may also offer matching contributions, further incentivizing employees to save for retirement. 403(b) plans are for schools, universities, churches, and non-profits

Both are named after the section of the IRS tax code that defines them. You don’t get to pick between these: what your company offers is what your company offers. 

Within each retirement plan type, your company may offer a few contribution options: pre-tax, Roth, and after-tax.

What are pre-tax contributions?

When you make a pre-tax contribution, the money is invested before taxes have been applied to your paycheck. The immediate benefit is a larger contribution to your retirement account plus a lower taxable income. The downstream impact occurs when you eventually withdraw the money – you must pay taxes on the amount contributed plus any growth that has occurred over the years you’ve saved. 

What are Roth contributions?

A Roth contribution is the opposite of pre-tax – that is, you pay income taxes now and then put that taxed money into the retirement account to invest. The immediate impact is a lower initial contribution amount plus your taxable income does not change, but the benefit is you’ll never have to pay taxes on that money again – including its growth! The additional benefit is it may be able to reduce your taxable income when you withdraw the money in the future since it does not in the current year. 

What are after-tax contributions?

After-tax is a third option to consider when saving for retirement in a 401(k) or 403(b) account. Note: this option is not offered by every company and is a source of savings outside of pre-tax or Roth. Like Roth, after-tax savings do not lower your current year taxable income as the contribution is made after you’ve paid taxes. Opposite of Roth, these after-tax contributions are treated as ordinary income and will be taxed upon withdrawal unless your retirement plan provisions allow for what’s called an “in-plan Roth conversion.” Since this contribution type is intended to maximize your savings beyond the current deferral limits for pre-tax and Roth, we’ll keep our focus to those two and allow you to read more about after-tax, here. 

Pre-Tax Roth
Contributions
  • Before-tax dollars
  • Tax-deductible; pay taxes later
  • After-tax dollars
  • Not tax-deductible; pay taxes now
Deferral Limit
Income Limit
  • 401(k) or 403(b) – No limit to participate
  • IRA – See IRS Limit
  • 401(k) or 403(b) -No limit to participate
  • IRA – See IRS Limit
Growth Tax-deferred Tax-free for qualified distributions
Taxation of Withdrawals Subject to federal and most state income taxes Tax-free for qualified distributions

Note: Employer contributions are taxed

For more information, see IRS comparison, including details for Roth 401(k) vs. Roth IRA.

Is it better to do pre-tax or Roth?

When a 401(k) or 403(b) retirement plan offers both pre-tax and Roth as deferral sources, employees can usually choose pre-tax, Roth, or a combination of both contribution types. These are separate sources of money to save within your retirement plan account.

It’s very common to advise younger people to invest through a Roth savings option, whether that’s an IRA, a 401(k), or a 403(b) because it’s generally assumed that they are in a lower income tax bracket than they will be later in their careers. Another benefit for younger folks is that they can take advantage of compound interest, knowing that all that growth is tax-free.

But the relationship between age and tax bracket isn’t quite that simple. We’d rather discuss your tax rate now than your expected withdrawal tax rate. At Brighton Jones, we like to consider this question annually and think about diversification since contributing to your retirement isn’t an all-or-nothing or one-and-done decision.

Instead of viewing the choice between pre-tax and Roth contributions as a binary decision or a quest to identify the superior retirement vehicle, it is more prudent to approach the decision as a means of creating a customized plan tailored to your specific financial circumstances and aspirations. By adopting a personalized approach and considering both the short-term and long-term implications, you can design a retirement strategy that aligns with your unique financial goals and helps you navigate the complexities of the tax landscape effectively. This approach emphasizes the importance of flexibility and adaptability, enabling you to make informed decisions that cater to your evolving financial needs and priorities.

Seven ways to maximize tax-advantaged retirement savings

1.) Choose both. The best news is that you don’t have to choose between traditional pre-tax and Roth savings options. You can split your contributions. Or, you can make an annual decision about which investment works better for you that year. Investing through both a traditional option and a Roth option is one way to create a diversified retirement portfolio and mitigate against your tax bracket at retirement being different than you anticipated.

2.) Invest in a traditional 401(k) and convert to Roth. Maybe you’re not ready to pay the taxes on a Roth right now. Your “no” this year doesn’t have to be a permanent no. In fact, if you time a conversion properly, you can lessen your tax liability. Or, perhaps you have traditional 401(k) savings, and you’d like to convert it now. A few signals a conversion could work for you: your traditional 401(k) has lost value, your income is low, or your deductions are very high. We recommend working with your financial advisor to determine your Roth conversion strategy and with your employer to confirm its availability within your retirement plan.

3.) Optimize your distributions. Once you hit 72, you’ll be required to take minimum withdrawals from your 401(k) regardless of its type. If you want to take more than the minimum, consider the tax implications of which savings source you draw from—if you’re in a lower marginal tax rate, you can withdraw from your traditional account. If your withdrawal would bump you into a higher rate, you can pull from your Roth savings instead. Additionally, if you are eligible for tax deductions in retirement, you’ll need taxes to take those deductions. A withdrawal from a traditional 401(k) can qualify you; you can withdraw just enough from that account to offset your deductions.

4.) Use Roth 401(k) savings to save for your heirs. If your account has been open for at least five years before your heir takes a distribution, they can make those withdrawals tax-free. They won’t need to pay taxes or consider the tax implications of withdrawing. You’ll have already taken care of that for them.

5.) Diversify your retirement accounts. Invest in a mix of pre-tax and Roth retirement accounts to create a diversified tax strategy. By spreading your contributions across different types of tax-advantaged accounts, you can potentially minimize the impact of future tax changes and optimize the tax treatment of your withdrawals during retirement.

6.) Regularly review and adjust your contributions. Reevaluate your retirement savings strategy periodically to ensure it aligns with your financial goals, income level, and tax situation. Adjust your contributions as necessary, especially in response to changes in income, family circumstances, and tax laws, to maintain an optimal balance between your current financial needs and long-term retirement objectives.

7.) Partner with a financial advisor. The right time to talk to a financial advisor is before you invest. Your situation is unique to you—just like your financial goals. Working with a fiduciary advisor means that you can work together to craft a plan for your retirement that works best for you. And because the question of investing in traditional or Roth 401(k) savings through your 401(k) isn’t a one-time choice, it’s a good idea to check in on your situation at least annually so you’re making the best move for you each year.

This post was originally published on July 22, 2020.

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Whether you have a specific question, or you’re interested in learning more about how our approach can be tailored to your situation, we’d love to hear from you.