When deferring to a workplace retirement plan, such as a 401(k), 403(b), or even a governmental 457 plan, most employees generally have two key alternatives:
- Pre-tax account (a.k.a. “traditional” option)
- Designated Roth account.
But, choosing between the two really boils down to one key thing: do you want to pay taxes now or later?
The Basics
Before diving into the specifics, it’s helpful to lay out the basics of how the two deferral types differ:
- Pre-Tax:Deferrals reduce your taxable income today, with contributions and earnings growing tax-deferred, and withdrawals taxed as ordinary income.
- Roth:Taxes are paid upfront, with contributions growing tax-free and qualified withdrawals – including earnings – withdrawn tax-free (in the case of earnings, as long as the 5-year rule is met).
If your employer’s retirement plan offers both pre-tax and Roth options, this provides you with additional latitude to control when you pay your taxes related to your retirement savings (pre-tax = later vs. Roth = now).
It’s the after-tax dollars that truly matter With retirement savings, after-tax dollars matter. Why? Because that’s what is left over once taxes are paid. This begs the question, “Would a person rather end up with more money, or less money, in their retirement account?” More, of course!
Retirement planning is not just about how much you save, but how much you keep of what you save, as what remains will fund your future lifestyle.
Naturally, the goal is to end up with more, not less. Will you benefit more in the long run from pre-tax or Roth? This all depends on future tax rates. If rates will be higher, this makes the long-term argument for Roth, whereas if rates will be lower, this bodes well for pre-tax. However, future taxes are only one piece of the equation.Why Pre-Tax Is Still the Default for Many
There are a few reasons that pre-tax deferrals remain the norm:
- They’ve been around longer (since 1978), while Roth options in employer plans became available in 2006.
- Not all plans offer a Roth option yet.
- Many plans use automatic enrollment, which often defaults to pre-tax; unless you proactively elect Roth, your deferrals will be pre-tax.
- Even when Roth is available, some employees mistakenly believe that they are unable to contribute to a Roth account due to income limits. Yes, income restrictions do exist within Roth IRAs, but Roth contributions within a workplace plan are acceptable at all income levels.
Some Unknown Factoids About Roth Roth has been around since 1997, thanks to the work of the late U.S. Senator William Roth (hence the namesake), who co-sponsored the law that enacted the Roth IRA. In 2006, the tax code was expanded to allow for Roth elective deferrals into qualified retirement plans such as 401(k) and 403(b). To reiterate what I noted above, unlike in the case of a Roth IRA, there are no income limits to contribute to a designated Roth account within an employer’s retirement plan. All are welcome regardless of income. Starting in 2025, as a result of SECURE 2.0, those 50 years of age or older making at least $145,000 in adjusted gross income annually can only make the catch-up deferral to a designated Roth account.1
Why Pre-Tax? Here are some common reasons why some employees may opt for making pre-tax deferrals:
- Immediate tax deduction:Lowers your taxable income today, increasing take-home pay, thereby lowering taxable income for the current tax year.
- Lower expected taxes in retirement: If you anticipate your income (and tax rate) will be lower in retirement, deferring taxes could mean paying less taxes overall.
- Potential current year tax savings for higher income earners:Generally speaking, current year tax deductions can often be the difference maker between eclipsing into a higher tax bracket in any given year.
- More take-home pay:Since pre-tax deferrals reduce your taxes, this translates into more take-home pay. For those who have higher short-term cash needs, this can be helpful.
- Roth deferrals aren’t matched:This is seldom the norm anymore, but some employers still only match pre-tax deferrals. For those employees who want to maximize employer match, this could mean deferring pre-tax in such an instance.
- No other tax deductions:If someone doesn’t have any other income tax deductions – e.g. student loan interest, mortgage interest – pre-tax deferrals may serve as an attractive means of a tax deduction.
Why Roth? Here are some common reasons why Roth may make sense for some:
- Higher expected taxes in retirement:In the event that taxes rise in the future will increase, paying taxes now (at a possibly lower rate) means that you can avoid not only paying taxes later (at a possibly higher rate).
- You’re young or in a low tax bracket:The younger someone is, the more time their retirement dollars will have to grow over time. Contributing after-tax dollars can mean more years of tax-free growth.
- You expect your income to grow:An expected salary increase may ultimately push someone into a higher tax bracket. Until that happens, Roth elective deferrals may provide an opportunity to put after-tax money away while in the lower tax bracket.
- The psychological impact of paying taxes: There could be saver’s remorse when someone sees a chunk of their retirement assets taken for taxes, which is often the case with pre-tax funds. With Roth funds, the taxes have already been paid, which offers some a feeling of satisfaction.
- Avoid paying future RMDs:Starting in 2024, there is no longer a required minimum distribution (“RMD”) on designated Roth accounts. Pre-tax funds, however, do carry an RMD.
- Qualified distributions are withdrawn tax-free:When taking a qualified distribution from a Roth account, deferrals and earnings come out tax-free, whereas pre-tax deferrals and earnings are taxed (and potentially penalized) when withdrawn.
What about employer contributions?
Traditionally, employer contributions are pre-tax since they allow employers a business tax deduction. So, in such instance, even if 100% of your deferrals are placed into a designated Roth account, you would still have pre-tax funds.
As a result of SECURE 2.0, Roth employer contributions are now a reality. This means that any such employer contributions, if the employer chooses to offer this option and provided an employee chooses to treat as Roth, would be taxed in the current year.Pre-tax vs. Roth… so which one’s better? I hate to burst your bubble, but the answer is… that there’s no “one-size-fits-all” answer. That said, =there’s a clear advantage to making Roth deferrals especially for younger savers (or those early on in their careers), or those who may anticipate a higher tax bracket later on. However, pre-tax offers the immediacy of tax savings (via deductions), and can be advantageous for those with near-term cash flow needs. And the reality is that pre-tax vs. Roth isn’t an all-or-nothing approach. In fact, some may split their deferrals between the two, whereas a benefit of the blended approach provides tax diversification in retirement. How someone decides to defer to their workplace retirement plan – whether pre-tax, Roth, or both – is completely up to them and a decision that should be based on their unique circumstances. And remember, the decision to defer pre-tax, or Roth, can always be changed. Irrespective of how one opts to defer their funds, the fact is, that their retirement assets will have the opportunity to increase in value over a long horizon. Summing It All Up Employees often ask me what to do, and my response is consistently the same—that it all depends on your personal situation. Even if I were in a position where I could render advice, my answer would remain the same. What I also suggest is that individuals consult with a financial planner or tax professional if they have one, or even to the financial advisor who oversees their employer-sponsored plan, for guidance. Many recordkeeper and bank websites, as well as financial wellness websites, have financial calculators that employees can access for free. Many of these calculators compare pre-tax and Roth elective deferrals. As with any online tools, these calculators provide estimates and come with imperfections. Don’t Forget The Big Picture While choosing between pre-tax and Roth (or opting to use both) is important, saving enough over the long run is paramount. According to the U.S. Department of Labor, savers should aim to have 70-90% percent of your pre-retirement income2 to maintain a similar standard of living in retirement. There are many recommendations on how much to save annually. Fidelity suggests a minimum of 15% annually.3 At the end of the day, achieving retirement readiness is about taking action:
- Decide how much to save annually.
- Determine your mix of pre-tax and Roth deferrals.
- Invest wisely, in alignment with your risk/reward tolerance.
- Implementing the above strategy.
- Adjust as needed over time.
Sources:
- Internal Revenue Service, https://www.irs.gov/newsroom/irs-announces-administrative-transition-period-for-new-roth-catch-up-requirement-catch-up-contributions-still-permitted-after-2023
- U.S. Department of Labor, https://www.dol.gov/sites/dolgov/files/ebsa/about-ebsa/our-activities/resource-center/publications/top-10-ways-to-prepare-for-retirement.pdf
- Fidelity, https://www.fidelity.com/viewpoints/retirement/how-much-money-should-I-save