Most company-sponsored retirement plans allow employees to defer compensation through traditional, pre-tax dollars and Roth dollars. What’s the difference?
There are generally two primary sources to save money within a company-sponsored retirement plan—401(k) or 403(b). The traditional, pre-tax, convention allows you to save a portion of your compensation tax-deferred, meaning you don’t have to pay current taxes on the amounts deferred into your retirement plan.
The Roth convention allows you to defer your compensation tax-free, as a separate source of money, meaning the amount deferred is included in gross income for that year and current taxes must be paid.
- Traditional (pre-tax): tax-deferred savings, where taxes are paid upon withdrawal.
- Roth: tax-free savings, where eligible distributions (including earnings) are generally tax-free.
Tax-deductible; pay taxes later
Not tax-deductible; pay taxes now
|Deferral Limit||See IRS Limit||See IRS Limit|
|Income Limit||No limit to participate||No limit to participate|
|Taxation of Withdrawals||Subject to federal and most state income taxes||Tax-free for qualified distributions|
For more information, see IRS comparison, including details for Roth 401(k) vs. Roth IRA.
How to Decide: Pre-Tax vs. Roth?
When a 401(k) or 403(b) retirement plan offers both pre-tax and Roth as deferral sources, employees can often choose pre-tax, Roth, or a combination of both. These are separate account sources of money to save within your retirement plan.
Here are some considerations to factor into your decision:
- Understand how your marginal tax rate now compares with your expected tax rate in retirement.
- How much do you plan to contribute? Will the amount you defer bring you to a lower marginal tax rate?
- How does this fit into your overall retirement plan?
- Understand retirement plan distribution rules (i.e., penalties, etc.).
Pre-Tax vs. Roth Example
Let’s say your income is $60,000, you contribute $10,000, and you are in the 22 percent tax bracket. Pre-tax contributions reduce your taxable income by the amount of your contribution.
|Annual Pre-Tax Contribution||$10,000|
*Based on 2020 tax tables for a single filer
From there, your contributions will grow until retirement and, upon withdrawal, the full amount (including any gains) are taxed at the tax rates for the year they are withdrawn. Generally, this would be a good option for an individual’s highest income years when deductions are more meaningful, or when someone is close to retirement age.
By contrast, Roth contributions do not receive a tax deduction in the current year. Even though it is not desirable to have a lower initial contribution, it is highly beneficial to know that you never have to pay tax on this money again. Both Roth contributions and gains are distributed tax-free upon retirement. Generally, this would be a good option when there are many years until retirement or for those in lower tax brackets.
Note: In both cases, withdrawals after age 591/2 avoid early withdrawal tax penalties. Roth accounts also have provisions that allow for withdrawal of initial contributions in certain situations. Consult your tax advisor to determine the option best for you.
There are plenty of positives to both pre-tax and Roth contributions to your 401(k) or 403(b). Having a diversified portfolio of assets can help you maximize your gains, especially if the future is unclear.