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

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?

We love that you’re interested in saving for retirement, whether that’s through an IRA or the tax-advantage retirement plan set up by your employer. If it’s the latter, you may have questions about the type of retirement plan your employer offers in addition to the allowable contribution options you have to choose from. We’ll share a bit more about each to help you with this decision. 

The type of retirement account your company offers is based on the organization type: 

• 401(k) plans are for for-profit companies 
• 403(b) plans are for schools, universities, churches, and non-profits

Both are named after the section of 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

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. 

Roth

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. 

After-tax 

 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. Similar to 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. 

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 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 talk about your tax rate now compared to your expected withdrawal tax rate. We also like to consider this question annually and think about diversification, since contributing to your retirement isn’t an all-or-nothing decision, nor is it a once-and-done decision. 

It’s not a given that your tax rate now will be lower than what you can expect in the future. Investing in both traditional and Roth savings is a way to hedge against an inaccurate prediction of your future tax rate. Plus, since higher income earners can’t participate in a Roth IRA, participating in a company-sponsored 401(k) or 403(b) offering Roth gives higher-income employees the chance to take advantage of its after-tax benefits.  

Rather than thinking about the decision in terms of making the right or wrong choice, or picking the best retirement vehicle, we like to re-frame the decision so it’s about making a plan that’s the best mix for you and your goals. 

5 Ways to Maximize Your Tax-Advantaged Retirement Savings

Choose both. The best news is that you don’t have to choose between traditional pre-tax and Roth savings option. 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.

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 figure out your Roth conversion strategy and with your employer to confirm that it’s available within your retirement plan.

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.

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

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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