Weighing Your Options: Pre-Tax vs. Roth Contributions to a 401(k) Retirement Account

When it comes to planning for retirement, one of the most important decisions you’ll make is how to contribute to your 401(k) account. Most employees have the option to make either pre-tax contributions or Roth contributions. Each has its own set of benefits and considerations and understanding the differences between the two options can help you make an informed decision that aligns with your financial goals. Let’s jump into some of the nuances of pre-tax vs. Roth contributions to a 401(k).

Pre-Tax Contributions

Pre-tax contributions to a 401(k) are made with dollars that have not been taxed. The money you contribute to the 401(k) reduces your taxable income for the year in which the contribution is made, potentially lowering your overall tax bill. Your contributions and earnings grow tax-deferred until you begin withdrawing funds in retirement. At that point, all withdrawals (contributions and growth) are taxed as ordinary income.¹

Advantages:

• Immediate Tax Benefits: Contributing pre-tax dollars to your 401(k) reduces your taxable income for the current year, potentially lowering your tax bill.
• (Potential) Lower Tax Bracket in Retirement: If you anticipate being in a lower tax bracket during retirement, making pre-tax contributions could result in paying less tax on future withdrawals than you would pay on that income now.
• Cash Flow: Pre-tax contributions reduce your taxable income fractionally. Meaning if you contribute $1,000 pre-tax to your 401(k) and your tax bracket is 30%, your take home pay will only be reduced by $700.

Roth Contributions

On the other hand, Roth contributions to a 401(k) are made with after-tax dollars. This means that you pay ordinary income tax on the money before it goes into your retirement account. However, qualified withdrawals of both contributions and growth in retirement are tax-free.¹

Advantages:

• Tax-Free Growth and Withdrawals: One of the most significant advantages of Roth contributions is your money grows tax-free and withdraws in retirement are also tax-free. This can be especially advantageous if you anticipate being in a higher tax bracket or if tax rates increase in the future.
• No Required Minimum Distributions (RMDs): Unlike traditional 401(k) accounts, Roth 401(k) accounts are not subject to RMDs during the account holder’s lifetime. This provides greater flexibility in managing retirement income and potentially allows for more tax-efficient estate planning.
• Diversification of Tax Treatment: By contributing to both pre-tax and Roth accounts, you can diversify the tax treatment of your retirement savings, providing more tax planning flexibility in retirement.

Which Option Is Right for You?

The decision of whether to make pre-tax or Roth contributions to your 401(k) depends on your individual financial situation, goals, and preferences. Here are some factors to consider:

• Current and Future Tax Bracket: If you expect to be in a higher tax bracket in retirement or if you believe that tax rates will increase in the future, Roth contributions may be more advantageous.
• Short-Term Cash Flow Needs: If you need to maximize your take-home pay in the short term, pre-tax contributions may be more appealing.
• Employer Match: Consider whether your employer offers matching contributions and whether those contributions are made on a pre-tax or Roth basis. As a note that really doesn’t pertain to this article, if your employer provides a match, I recommend doing everything in your power to get the full match.

Anecdotally

Looking at most of the published projections comparing pre-tax vs. Roth 401(k) contributions the results show that if you are going to be in a lower tax bracket in retirement, you should contribute pre-tax to your 401(k). While I agree with the projections because the math is correct, I feel they fail to account for tax rate uncertainty and “human factors.”

We do not know what changes will be made to tax brackets 40, 30, or even 20 years from now; they could go down, they could go up, or they could stay the same. From 1913 until 2023, the highest marginal income tax rate ranged from a low of 7% to a high of 94%. Between 1964 and 1981 it was in the 70-80% range and has been in the 35-39% range since 1993. Income tax rates are going back up in 2026 with the sunset of the TCJA, that is of course assuming no other changes are introduced between now and then.

One of the main “human factors” that many of the projections do not account for is that most people do not invest the tax savings they are getting from pre-tax contributions. I have yet to have a client say to me “the annual contribution limit is $22,500 but I save $6,750 in taxes by making pre-tax contributions (assuming a 30% tax bracket) so I’m going to put that money into a taxable brokerage account for the future.” In fact, as I was writing this blog, I realized I wasn’t even doing this (which I promptly corrected)!

Wrapping Up

The decision to make Roth or pre-tax contributions to your 401(k) is a personal one that depends on various factors, including your current financial situation, tax outlook, and retirement goals. Evaluating these factors carefully and consulting with your financial advisor can help you make an informed decision that aligns with your long-term financial objectives. Remember, both options offer valuable tax advantages, and the key is to choose the approach that best suits your individual needs and circumstances.

¹Please note that there are restrictions on when you can start drawing from retirement funds, both pre-tax and Roth, without penalty.