The decision of whether to make pre-tax or Roth (after-tax) 401(k) contributions frequently pops up, especially when investors start new jobs. Both pre-tax and Roth 401(k)s offer tax-advantaged investment growth, the same annual employee contribution limits, and both allow the plan participant to receive any available employer match. However, there are key differences between these options, so it is important to understand the pros & cons before electing whether pre-tax, Roth, or a combination of the two is appropriate for you.
What is the difference between pre-tax and Roth?
There are two primary differences – both of them are tax related.
- A Roth 401(k) is funded with post-tax dollars from your paycheck. You are paying taxes upfront, which allows funds within Roth 401(k) to be tax-free forever.
A pre-tax 401(k) has the opposite circumstances. Contributions are made with before-tax dollars, which lowers your taxable income for the given year. If your current marginal tax rate is 30%, a $10,000 pre-tax contribution to a 401(k) will generate a $3,000 tax savings as compared to a Roth 401(k) contribution, which has no tax savings. The trade off is that withdrawals taken from the plan down the road are treated as ordinary income.
- When you turn 70.5, you are required to take an annual minimum distribution (RMD) from your pre-tax accounts (including traditional IRAs) so that the government can begin receiving its share of the income you deferred. The required withdrawals are based on the IRS RMD worksheet and the mandated percentage continues to increase as you age. The initial withdrawal percentage starts at 3.65%, so if your prior year-end pre-tax 401(k) balance was $1MM, your initial RMD will be $36,500. If you pass away with an IRA, your heirs will have to take RMDs from the inherited IRA.
Roth 401(k)s technically have an RMD requirement as well, but that can be circumvented by rolling your balance into a Roth IRA. Regardless, distributions from either a Roth 401(k) or a Roth IRA are tax-free because taxes have been paid upfront.
Factors to weigh when making your decision
First, there is no right or wrong answer and the important thing is that you contribute as much as you can. The maximum employee contribution in 2019 for pre-tax, Roth, or an aggregate combination of the two is $19,000 ($25,000 if you are over 50). It is also worth noting that any employer match you receive will always be pre-tax regardless of your election, so even if you are making 100% Roth contributions into the plan you will naturally have some diversification across tax profiles.
The election decision can be boiled down to two variables: 1) whether you prefer to pay taxes now or later, and 2) what your tax rate will be at both of those points in time. If you expect your income to increase in the future, which would likely increase your marginal tax rate, then Roth contributions are compelling because you are locking in your tax rate now. Additionally, if you believe income tax rates will increase in the future or you plan to move to a higher income tax state at some point, Roth contributions could be beneficial. By contrast, if you believe your marginal tax rate will decline in retirement, a pre-tax 401(k) contribution is a logical decision. Keep in mind that even if your contribution rate is held constant, your net paycheck will be lower if you are making Roth contributions, so you should plan for that within the context of your ongoing cash flow needs.
There is no crystal ball to determine what the future will hold, so why not diversify your retirement accounts? By utilizing both a Roth 401(k) and pre-tax, you are securing funds in a tax-free account while also reducing your current taxable income. We implore clients to invest in multiple asset classes to reduce risk, and the same argument can be applied to your retirement savings.
If you decide to diversify, that does not mean you will have two 401ks or have more administrative work to handle. The plan provider will show your balance and allocation as one total, but you will have the ability to view your account by contribution source to see the pre-tax vs. Roth breakdown. Also, the majority of 401(k) providers allow participants to alter their contribution elections and rates without limitation so feel free to tinker until you arrive at a comfortable level. As I mentioned previously, the most important thing is to keep increasing your contribution rate until you reach the maximum! And if you are wondering what to do with your old 401k feel free to check out this post.