Roth vs Pre-Tax Retirement Contributions – Which One Is Right for you?

Authored by Taylor Warren, CFP^®

One of the many crucial decisions that go into optimizing your financial planning is choosing the right type of tax treatment for your retirement account contributions. Today, many employer retirement plans offer both Pre-Tax and Roth contribution options for employees to choose from. Both options come with their own set of advantages and considerations, making it critical to understand the differences before making a choice. In this brief guide, we'll break down the key features of each to help you make an informed decision for your own financial future.

Understanding Pre-Tax Contributions

Pre-tax contributions involve investing money into your retirement account before taxes are deducted from your paycheck. This reduces your taxable income in the current year, potentially lowering your tax bill. However, withdrawals from pre-tax retirement accounts such as traditional 401(k)s and IRAs are taxed as ordinary income in retirement.

Pros of Pre-Tax Contributions:

1. Immediate Tax Benefits: Pre-tax contributions lower your taxable income in the year of contribution, potentially reducing your current tax bill and increasing your take-home pay.
2. Future Tax Planning: If you believe you’ll be in a lower income tax bracket in retirement, you could benefit greatly by delaying taxes until then.

Cons of Pre-Tax Contributions:

1. Taxable Withdrawals: Withdrawals from pre-tax retirement accounts are taxed as ordinary income in retirement, potentially subjecting you to higher tax rates depending on your income and tax bracket at that time.
2. Required Minimum Distributions (RMDs): Pre-tax retirement accounts typically require you to start taking RMDs after reaching age 73 (depending on your date of birth), which can impact your retirement income strategy and potentially increase your taxable income. For some individuals, these RMDs can be substantially more than the income they need in retirement, and can push the account owner into a higher income tax bracket than they otherwise would experience.
3. Limited Flexibility: Unlike Roth contributions, pre-tax contributions do not allow for tax-free withdrawals of contributions, meaning you'll pay taxes on both contributions and earnings upon withdrawal.

Understanding Roth Contributions

Roth contributions involve investing money into your retirement account after taxes have been deducted from your paycheck (you’re paying the taxman today, versus delaying until retirement). The main advantage of Roth contributions lies in their tax treatment upon withdrawal in retirement. Since you've already paid taxes on the contributions, withdrawals—including both contributions and earnings—are tax-free in retirement, as long as you meet certain conditions. This tax-free growth potential can be a significant advantage in retirement, especially if you anticipate being in a higher tax bracket at that time.

Pros of Roth Contributions:

1. Tax-Free Withdrawals: Enjoy the flexibility of tax-free withdrawals in retirement.
2. No Required Minimum Distributions (RMDs): Unlike traditional pre-tax retirement accounts, Roth IRAs do not mandate withdrawals during your lifetime, allowing for added control over your retirement income strategy.
3. Over the life of the investment (which in many cases will be longer than the account owner’s lifetime), taxes are paid on a lesser amount of money than with a pre-tax investment account.

Cons of Roth Contributions:

1. Upfront Taxation: Roth contributions are made with after-tax dollars, which means you won't receive an immediate tax break on your contributions, potentially reducing your take-home pay and in certain circumstances can also move you into a higher marginal income tax bracket.
2. Income Limits: Roth IRA contributions are subject to income limits, meaning high earners may not be eligible to contribute directly to a Roth IRA. This does not apply to Roth 401(k) contributions.

The Great Unknown: Future Tax Environment

While Roth withdrawals are tax-free in retirement under current tax laws, future legislative changes could impact the tax treatment of Roth withdrawals. The inverse of this also holds true: those who choose pre-tax contributions today believe they may be in a lower tax bracket in retirement. That belief is based on the assumption that current tax laws will remain in your favor in the future.

Conclusion:

Choosing between Roth and Pre-Tax contributions requires careful consideration of your current financial situation, future retirement goals, and tax implications. This choice is unique for every individual and family. While Roth contributions offer tax-free withdrawals in retirement and greater flexibility, pre-tax contributions provide immediate tax benefits. Ultimately, the best approach may involve a combination of both Roth and Pre-Tax contributions, tailored to your individual needs and guided by the advice of a financial planner. By understanding the differences between these two options, you can take proactive steps towards optimizing your retirement savings and securing a comfortable financial future.

A Step Further: Considering your Heirs

When you leave assets from a Pre-Tax IRA to your children or heirs, they may be severely impacted by the distribution rules with inherited Pre-Tax IRAs. Current tax law requires the funds in the account to be withdrawn by the beneficiary within 10 years of inheritance – potentially forcing the beneficiary into a higher income tax bracket and losing a significant portion of the inheritance to income taxes. Under current tax laws, inherited Roth IRA withdrawals are typically tax-free. This is an important consideration and could substantially impact your heirs.

PS – Tips for Future Success

Whichever tax treatment you choose for your retirement contributions, if you’re not reaching the annual maximum contribution amount you should strive to increase your contribution percentage by 1% (at minimum) every year. Many employer retirement plans now offer an automatic increase feature in your online account that you can turn on, which will automatically increase your contribution percentage annually.

Setting your annual contribution in dollar-denominated amounts versus a percentage amount is a common mistake plan participants make. Ensure your contribution is set as a percentage, so when your income increases in the future, so does your contribution amount. Monitor your contributions often. In many retirement plans, you can make changes between Roth and Pre-Tax contributions throughout the year.

Neither Raymond James Financial Services nor any Raymond James Financial Advisor renders advice on tax issues, these matters should be discussed with the appropriate professional.

Opinions expressed in the attached article are those of the author and are not necessarily those of Raymond James. All opinions are as of this date and are subject to change without notice. Prior to making an investment decision, please consult with your financial advisor about your individual situation.

Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® (with plaque design) in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.