Roth and Pre-tax contributions are like the dynamic duo of retirement planning. But what’s the difference, and which one should you choose for your unique money journey? Let’s dive in and figure it out! Understanding the Roth vs pre-tax options could help you make a better-informed decision.
Understanding the Difference Between Roth vs Pre-Tax Contributions
When it comes to saving for retirement, you’ve got options. Lots of them. However, two things that often get confused are Roth contributions and pre-tax contributions. They sound similar, but some key differences can greatly impact your retirement savings.
Roth Contributions vs Traditional Pre-Tax Contributions
First, let’s talk about Roth contributions. With a Roth 401(k), you contribute money that is already taxed. So, you don’t get a tax break upfront like you do with traditional pre-tax contributions.
But here’s the kicker: when you retire, you can generally withdraw your Roth contributions and any earnings tax-free. Yep, tax-free.
On the flip side, with traditional pre-tax contributions, you generally get a tax deduction for the contribution, but you’ll pay taxes on your withdrawals in retirement. It’s kind of like paying now or paying later.
Pre-Tax Contributions vs Roth Contributions
Now, let’s talk about pre-tax contributions. However, unlike Roth contributions, you will have to pay taxes on your distributions when you withdraw the money in retirement.
Tax Treatment of Different Contribution Types
The tax treatment is the key difference between these contribution options. With Roth contributions, the funds have already been taxed, so your withdraws are typically tax-free later.
With traditional pre-tax contributions, you typically get a tax deduction now but pay taxes on the distributions.
Advantages of Making Roth Contributions
So why go Roth? There are a few big advantages:
Tax-Free Growth and Withdrawals
The biggest advantage of Roth contributions is the potential for tax-free growth and withdrawals. Once you hit age 59½ and your Roth account has been open for at least 5 years, you can take out your contributions and earnings tax-free. That can be a huge benefit, especially if you expect to be in a higher tax bracket in retirement.
Think about it: would you rather pay taxes on the seeds or the harvest? With a Roth, you’re paying taxes on the seeds (your contributions), but the harvest (your earnings) is all yours, tax-free.
No Required Minimum Distributions (RMDs)
Another advantage of Roth accounts is that they’re not subject to Required Minimum Distributions (RMDs). With traditional pre-tax retirement accounts, you have to start taking money out at age 73, even if you don’t need it.
But with a Roth, you could let that money keep growing tax-free for as long as you want. This can be a great option if you don’t need the money right away in retirement or if you want to leave some tax-free money to your heirs.
Flexibility in Retirement Income Planning
Having some money in Roth accounts could also give you more flexibility in retirement income planning. You could mix and match your withdrawals from pre-tax and Roth accounts to manage your tax liability in retirement. This is relevant for someone who has opted to invest in BOTH pretax (Traditional) and post-tax (ROTH).
For example, let’s say you retire in a year when you have a lot of other taxable income. You could take more money out of your Roth account that year to avoid bumping yourself into a higher tax bracket. Then, in a year when you have less taxable income, you could take more from your pre-tax accounts. Optionality is incredibly valuable, especially when attempting to plan for a future with changing tax codes, shifting economic/market dynamics, and even personal uncertainty.
Benefits of Pre-Tax Contributions
While Roth contributions get a lot of the glory, pre-tax contributions have some perks too:
Ability to Contribute Beyond Roth IRA Limits
One of the biggest benefits of pre-tax contributions is the ability to save more for retirement. In 2024, the contribution limit for Roth and traditional 401(k)s is $23,000 (or $20,500 if you’re 50 or older).
However, with pre-tax contributions, you can contribute up to $69,000 total (plus another $3,500 if you’re 50+), including your pre-tax or Roth contributions and any employer match.
So, if you’ve maxed out your Roth or pre-tax contributions and you still want to save more, pre-tax contributions give you that option. This is specific to certain types of retirement plans provided through the person’s company and is not true for everyone.
Potential for Tax Diversification
Making Pre-tax contributions could also provide tax diversification. Just like diversifying your investments, it could be smart to diversify your retirement savings from a tax perspective.
Having some money in pre-tax accounts and some in Roth accounts gives you more flexibility to manage your tax liability in retirement. You can pull from different buckets depending on your tax situation each year.
Option to Convert to Roth Later
You’ll pay taxes on any earnings in the year of conversion, but then that money grows tax-free and can be withdrawn tax-free in retirement. Not all plans allow for in-plan conversions of pre-tax money to Roth, but if yours does, it could be a smart way to get more money into Roth accounts, especially if you’re a high earner. This refers to retirement plans through a company instead of IRAs.
Factors to Consider When Choosing Between Roth and Pre-Tax Contributions
So, how do you decide between Roth and Pre-tax contributions? Here are a few factors to consider:
Current and Expected Future Tax Brackets
Your current and expected future tax brackets are a big factor in deciding between Roth and pre-tax contributions. If you think you’ll be in a higher tax bracket in retirement, Roth contributions may make more sense since you’re paying the taxes now at a lower rate.
But if you think you’ll be in a lower bracket in retirement, pre-tax contributions may be the way to go. The qualifier is that we don’t always know how our tax bracket will change with time. It depends on our own unique earning situation, what types of accounts we currently have, what amounts are in each account, and changing tax laws. Knowing all of those years or even decades in advance is very difficult, so the goal is to put the probabilities in our favor by taking a diversified approach.
Retirement Savings Goals
Your overall retirement savings goals can also impact your decision. If you’ve already maxed out your pre-tax or Roth contributions and have funds left to invest, consider supporting your cash cushion or opening a taxable account (These are called brokerage accounts and can be owned individually or jointly).
Access to Professional Advice
These decisions can get complex, especially when you factor in your specific financial situation. That’s where professional advice could be really valuable.
Holistic Fiduciary Advisors can help you navigate these decisions early and often with the goals of providing projections into the future, and guiding you through decisions while staying mindful of all the changing variables.
Maximizing Your Retirement Savings with Roth and Pre-Tax Contributions
At the end of the day, the goal is to save as much as you can for retirement in a way that works for your situation. Roth and pre-tax contributions are two tools that can help you do that.
Understanding Contribution Limits
To make the most of these options, it’s important to understand the contribution limits. In 2024, if you are under 50, you can contribute up to $23,000 to a 401(k), whether that’s pre-tax, Roth, or a combination.
If you’re 50 or older, you can contribute an additional $7,500 for a total of $30,500.
Utilizing Employer Matching Contributions
Workplace-sponsored retirement plans (401ks, 403Bs, SIMPLE IRAs, etc.) often have what is called an ’employer match.’ This refers to if you commit to putting a portion of your salary into your workplace retirement plan for yourself, then the company will also match your contribution up to a certain amount.
For example, your employer might match 50% of your contributions up to 6% of your salary. So, if you make $100,000 and contribute at least 6% ($6,000), your employer would kick in an additional $3,000.
That match usually goes into a pre-tax account, but it still counts toward your overall contribution limit. The overall contribution limit is not the same as the employee contribution limit. So make sure you’re contributing enough to get the full match, even if you’re focusing on Roth or pre-tax contributions.
Developing a Comprehensive Retirement Savings Strategy
Ultimately, the key is to develop a comprehensive retirement savings strategy that takes into account your current situation, your future goals, and any employer benefits. That might include a mix of pre-tax, Roth, and brokerage contributions.
It’s not always a one-size-fits-all approach. What works for your coworker or your neighbor might not be the best strategy for you. That’s why it’s so important to educate yourself on the options and seek professional advice if you need it.
But by understanding the differences between Roth and Pre-tax contributions and weighing the factors that impact your decision, you can create a retirement savings plan that sets you up for success. And that’s all about taking control of your financial future and possibly a comfortable retirement, whatever that looks like for you.
Roth vs Pre-Tax: Final Thoughts
So, there you have it – the lowdown on Roth vs pre-tax contributions. We’ve covered the differences in tax treatment, flexibility, and how they can impact your retirement savings strategy. It’s not a one-size-fits-all situation, and that’s okay!
The best choice for you depends on your unique financial picture, both now and in the future. If you expect to be in a higher tax bracket down the road, Roth contributions might be for you. But if you’re looking for a little more flexibility and don’t mind paying taxes on your earnings later, pre-tax contributions could be the way to go.
For more information or to speak with highly experienced wealth managers, get a free assessment with Riverbend Wealth Management today.
Disclosures:
Investment advice is offered through Stratos Wealth Advisors, LLC, a registered investment advisor, DBA Riverbend Wealth Management.
This content is developed from sources believed to be providing accurate information and provided by Riverbend Wealth Management. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stratos Wealth Partners and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.
