How to choose between pre-tax contributions and Roth 401(k) contributions
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Whether you’re starting a new job or updating your retirement savings goals, you may need to choose between pre-tax contributions or Roth 401(k)—and the choice may be more difficult than you think.
While pre-tax 401(k) deposits offer upfront tax credits, funds grow with tax deferral, meaning you have to pay fees when you withdraw funds. In contrast, Roth 401(k) contributions occur after taxes, but your future earnings grow without taxes.
Most plans have both options. Approximately 88% of 401(k) plans offered Roth accounts in 2021, almost double the number from ten years ago. Council of America plan sponsorduring which more than 550 employers were interviewed.
While your current and future tax brackets are part of the puzzle, experts say there are other factors to consider as well.
“It’s hard to speak in general terms because there are so many things that go into making this decision,” said certified financial planner Ashton Lawrence, partner at Goldfinch Wealth Management in Greenville, South Carolina.
Here’s how to decide what’s right for your 401(k).
Compare current and future tax brackets
Experts say one important question to consider is whether you expect to be in a higher or lower tax bracket when you retire.
In general, according to Lawrence, pre-tax contributions are better suited to higher-earning individuals due to upfront tax credits. But if your tax bracket is lower, paying fees now with Roth deposits might make sense.
If you’re in the 22% or 24% group or below, I think Roth’s contribution makes sense, assuming you’ll be in the higher group when you retire.
Lawrence Pont
CPA at Pon & Associates
Lawrence Pon, CFP and Pon & Associates Certified Public Accountant in Redwood City, Calif., said Roth 401(k) contributions are generally good for younger workers who expect to earn more later in their careers.
“If you’re in the 22% or 24% or below group, I think Roth’s contribution makes sense, assuming you’re in the higher category when you retire,” he said.
“Taxes are sold” until 2025
While it is not clear how Congress can change tax policy, certain provisions of the Tax Cuts and Jobs Act of 2017 which expires in 2026, including lower tax brackets and a higher standard deduction.
Experts say these expected changes could also factor into the analysis of pre-tax contributions versus Roth’s contributions.
“We’re in this low-tax sweet spot,” said Katherine Valega, CFP and founder of Green Bee Advisory in Boston, referring to the three-year period before tax brackets can get higher. “I say the taxes go to the sale.”
We are in this sweet place with low taxes.
Ekaterina Valega
Founder of Green Bee Advisory
While Roth’s deposits are no problem for low-income young people, she said the current tax environment has made these deposits more attractive to higher-income clients as well.
“I have clients who can get $22,500 over three years,” Valega said. “That’s a pretty good part of the change that will grow without taxes.”
In addition, recent changes to Secure 2.0 have made Roth 401(k) deposits more attractive to some investors, she said. Plans can now offer Roth employer matches, and Roth 401(k) no longer requires a minimum allocation. Of course, plans can vary depending on what features employers decide to accept.
Many investors also consider “obsolete targets”.
Lawrence of Goldfinch Wealth Management said “legacy goals” are also a factor in choosing between pre-tax contributions and Roth contributions. “Property planning is becoming an increasingly important part of what people actually think about,” he said.
Since the Security Act of 2019, tax planning has become more difficult for legacy IRAs. Previously, non-spousal beneficiaries could “stretch” withdrawals throughout their lives. But now they must exhaust legacy IRAs within 10 years, known as the “10-year rule”.
The withdrawal schedule is now “much more compact, which can impact the recipient, especially if they are in their peak earning period,” Lawrence said.
However, Roth IRAs may be “a better estate planning tool” than traditional pre-tax accounts because non-spousal beneficiaries will not pay taxes on withdrawals, he said.
“Everyone has their own preferences,” Lawrence added. “We’re just trying to provide the best options for what they’re trying to achieve.”
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