Desperation

Pre-Tax or Roth 401(k) Contributions: What Should I Do?

Desperation

As we've covered in the past, choosing between a traditional or Roth 401(k) account in your workplace retirement savings plan can be a tough decision. These types of features are similar to options made available to most investors through separate Individual Retirement Accounts (IRAs). 

In general, a traditional 401(k) or IRA account lets you contribute pre-tax savings that can grow on a tax-deferred basis. With a Roth account, you pay taxes upfront but not on the back-end once you retire. 

To help sort out these differences, below is an overview of some of the key features of each that you might find interesting to explore through your employer-sponsored 401(k) plan.

Definitions:

Pre-Tax 401(k) Contributions: Contributions are made before income taxes are taken out. Participants enjoy tax-deferred growth on their contributions, but will pay income taxes on disbursements in retirement.

Roth 401(k) Contributions: Contributions are made after income taxes are taken out. Participants, however, will enjoy tax-free growth of their contributions and disbursements in retirement are also tax-free.

Example:

Jane Smith earns $75,000 per year and wants to contribute 10% of each paycheck ($288) to her 401(k). Her marginal federal income tax rate is 25%. If she decides to make pre-tax contributions to her 401(k), she will forgo paying taxes on contributions and $288 will be deposited into her 401(k) each pay period. On the other hand, if she decides to make Roth contributions, she will have 25% deducted from each contribution for income taxes and $216 will be deposited into her 401(k) each pay period.  

Which is Better? It Depends ...

If Jane's marginal federal income tax rate does not change over her working life and into retirement, then it doesn't matter which election she makes in terms of her contributions. Here is why:

Let's assume Jane contributes $288 each pay period for 30 years and earns an 8% rate of return. If she makes pre-tax contributions, her ending balance in 30 years will be $937,249.49 on a pre-tax basis. Its after-tax value would be $702,937.12 after paying $234,312.37 in income taxes (25%).

If she instead made Roth contributions (after-tax), her ending balance would be $702,937.12 on an after-tax basis. Notice how each scenario winds up with the same after-tax value, so Jane could of done either and ended up in the same exact place in retirement. (See chart below.)

General Rules

  • Pre-tax contributions may make sense for investors who expect to be in a lower tax bracket in retirement compared to today. You forgo paying income taxes on contributions at the higher rate now and pay taxes on disbursement at the lower rate in retirement.
  • Roth contributions (after-tax) may make sense for investors who expect to be in a higher tax bracket in retirement compared to today. You pay income taxes on contributions now at the lower rate and forgo paying taxes on disbursement in retirement at the higher rate.
  • If you expect to be in about the same tax bracket now versus in retirement, then you can diversify your tax exposure and do a little bit of both.

Quick Facts:

  • You can save in a Roth 401(k), a pre-tax 401(k), or a combination of both as long as you stay under the total contribution limit for the year ($19,500 or $26,000 if age 50 or older in 2021.)
  • Investment options are consistent across both Roth 401(k) and pre-tax 401(k).
  • If you rollover your Roth 401(k) to a Roth IRA at retirement, you can forgo required minimum distributions (RMDs) that are associated with pre-tax 401(k)s, Traditional IRAs, or Rollover IRAs.
  • When you leave the company, you can rollover your Roth 401(k) to another Roth 401(k) if your new employer offers one or a Roth IRA. Similarly, you can rollover your pre-tax 401(k) to your new employer's 401(k) or a Rollover IRA.

It's also important to remember in choosing between a pre-tax and Roth 401(k) account that no right or wrong solution exists for everyone. If you'd like more clarity on which type of retirement account might best suit your personal financial situation, please feel free to contact an IFA wealth advisor. You can reach us at: (888) 643-3133. 


This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, service, or considered to be tax advice. There are no guarantees investment strategies will be successful. Investing involves risks, including possible loss of principal.

This is intended to be informational in nature and should not be construed as tax advice. IFA Taxes is a division of Index Fund Advisors, Inc.