If you’ve contributed to your company’s retirement plan, you have probably faced the decision of contributing pre-tax dollars or after-tax dollars. Although pre-tax is the traditional option for 401(k) contributions, many plans now offer Roth after-tax contributions as well. When deciding between the two options, it is important to understand that one is not necessarily better than the other, and there is not a one-size-fits-all approach for what is best for every person. Instead, it depends on your situation.
Ultimately, it’s a tax decision. The government is entitled to their share, but it is up to you to decide when they collect their share. If you contribute pre-tax dollars, you get to keep more of what you invest now and give Uncle Sam his cut later. If you contribute Roth dollars, you give Uncle Sam his cut now and keep more later. There are two important rules to keep in mind:
- Always pay taxes at the lowest rate.
- The lowest lifetime tax bill wins.
With that in mind, let’s look at the benefits of each and when it would make sense to contribute pre-tax dollars versus Roth.
Pros of pre-tax 401(k)
- Contributions are deducted from your taxable income. The biggest advantage of pre-tax contributions is the immediate income tax deduction. You can contribute $22,500 to a 401(k) each year, so you can lower your current taxable income by up to $22,500 if you make the maximum amount. This deduction can result in a lower tax bill in the year you make the contributions.
- Decades of tax-deferred growth. In addition to the tax-deductible contributions, you get to defer any growth and income in a pre-tax 401(k). The interest, dividends and capital gains that are paid in a non-retirement savings account are all subject to taxes when they’re incurred, regardless of what you do with them. In a pre-tax 401(k), you can defer these payments.
- You can convert to Roth. Some say pre-tax is always the best choice because you can convert the pre-tax funds to Roth in most 401(k) plans that offer both options. Like anything in personal finance, there is no such thing as “one size fits all,” so it depends on your situation. However, the ability to convert to Roth is a great benefit of pre-tax savings. Because you avoided taxes on the contribution, you will owe ordinary income tax on every dollar you convert to Roth.
When is it good to use pre-tax?
- When your tax bracket is expected to be lower in retirement than it is now. Most people will likely be in a lower tax bracket in retirement than in their working years. Remember the rule of paying taxes at the lowest rate: If your rate in retirement is expected to be lower, then it makes sense to get the deduction at the higher rate (when you contribute) and pay a lower rate when the funds are distributed.
- Investment choices in your 401(k) are not great. If your 401(k) plan only offers a handful of funds with high fund expenses, it may not be in your best interest to save every available dollar here. However, you can still make pre-tax 401(k) contributions to get the deduction and use your retirement account to invest in more conservative asset classes like bonds. If you have additional funds to invest, you can use other investment accounts to allocate those savings to asset classes with higher expected returns. This maximizes the dollars you have invested and minimizes your future required minimum distributions (RMDs).
- Your retirement accounts might solely be passed to beneficiaries. Many high-net-worth individuals find themselves having enough income and other assets to fund retirement without touching their retirement accounts. When this happens, the focus can turn to the beneficiaries that will inherit them and how to pass those funds on most efficiently. If a soon-to-be retiree is in the 35% bracket, expects to be in the 24% bracket in retirement, and has beneficiaries that don’t ever expect to reach the 24% bracket, it can make sense to get the deduction now on the contribution and let the owner at the time of the distribution pay the taxes at a rate below 24%.
Pros of Roth 401(k)
- Decades of tax-free growth and withdrawals. The biggest pro of Roth contributions is that this money is never taxed again (if the distribution rules are met). You do not get the income tax deduction immediately like you get from pre-tax contributions, but if your contributions grow tax free for decades, this can result in a large balance of tax-free assets in later years.
- Keep more of your paycheck later, in retirement. Since you’re taxed on the contribution only, you can keep more of your paycheck in retirement. Unless the cost of living starts to decrease as time goes on (the opposite of what is typical), the extra dollars you keep might make more of a difference than the deduction you get now.
- No required minimum distribution. Until recently, both Roth and pre-tax 401(k) funds were subject to RMDs. RMDs are a minimum dollar amount that you must take out of the account once you reach age 72, 73 or 75, depending on your birth year. However, legislation passed at the end of 2022 changed that. Now, pre-tax 401(k) money is subject to required distributions while Roth 401(k) money is not. So, it’s up to you when you take the money out of a Roth 401(k).
- Ability to contribute $22,500 to Roth with no income limits. The maximum contribution you can make to both Roth and pre-tax 401(k) is $22,500 (and an additional $7,500 if you’re 50 or older). Simply put, this is a lot of money to invest in a tax-free manner. All else being equal, if you do the math, you can expect that your withdrawals will be worth more than your immediate deduction. If you deduct $22,500 you exclude exactly $22,500 from taxable income. If you contribute $22,500 now and it grows by investment rates of return, you will have an even larger sum that avoids taxes later.
When is it good to use Roth?
- When you’re in a lower tax bracket now compared to what you’ll be in retirement. It’s not that common to expect to be in a higher bracket in retirement than in your working years; however, it still happens. A common situation for this is if you’re toward the end of your career, working and earning less as you ease into retirement, and you already have significant pre-tax assets. If you have a large pre-tax bucket at this stage, you might have large RMDs, so it could make sense to work on building your tax-free nest egg.
- You expect tax rates to increase in the future. Just like forecasting the market, it’s a fool’s game to try to forecast tax rates. However, today they are historically low, so intuitively we can only expect them to go up. The Tax Cuts and Jobs Act (TCJA), which sets the current tax rates, is set to expire in 2025. The expiration of TCJA will result in a change of rates unless further legislation is passed to do otherwise. If current rates are lower than future rates, it makes sense to pay tax on your contributions now.
- You’re early in your career and expect your income to increase as your career goes on. The farther you are from retirement, the more time you have for the contributions to grow. With your income lower than it will be as you progress in your career, you are paying a lower rate on the contributions versus the distributions, since these would be tax free. The lower your income is, the more likely you’ll be eligible for certain tax credits, so you can potentially find tax deductions elsewhere early on.
When assessing your options, remember to pay taxes at the lowest rate and strive for the lowest lifetime tax bill. Your financial advisor can also help answer questions about choosing between pre-tax or Roth in your 401(k).
For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based on third-party data and may become outdated or otherwise superseded without notice. Third-party information is deemed reliable, but its accuracy and completeness cannot be guaranteed. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this presentation. R-23-5646
As an associate wealth advisor, Brandon Dingman is the connection between our clients, the support team and advisors. This includes the support and preparation of the financial plan development, client onboarding process, and portfolio management. Brandon joined Buckingham Strategic Wealth in the fall of 2021. Previously, he has worked within financial services and the technology industry, most recently as an associate advisor and trader at Siena Investments.