Pre-Tax vs Roth

Perhaps one of the least understood aspects of retirement preparation is the proper use of the Pre-tax vs. Roth features in your retirement plan.

While the Roth option has been available since the beginning of 2006, it took years for most employers to add the feature, and even to this day, most are not able to provide a concise explanation as to how to choose between the two options.

When you invest in your future in a 401(k), you receive a tax benefit. The timing of that tax benefit is the primary difference between Pre-tax and Roth.

Pre-tax deferrals, as the name suggests, are deducted from payroll before the taxes are calculated. Earnings in a pre-tax position also grow on a tax-deferred basis for as long as the funds remain in a qualified account.

Of course, all good things end, and when you take a distribution from the pre-tax account, you will have to claim that amount as income on your taxes. Distributions taken before age 59 ½ will likely be subject to a 10% penalty in addition to the taxes. 

Using the Roth deferral feature requires that you forego the tax savings at the time of deferral.  Every dollar saved is included in taxable income in the year it is contributed to the retirement account. If done correctly, both the initial investment and the growth may be distributed tax-free in retirement. To ensure tax-free distributions, you must be at least 59 ½ years old and have had the Roth set up for five years.

So, which one is the better option? That depends on your situation and your ability to foretell the future.

We can all agree that we want to pay our taxes at the lowest rate possible. If you think you will be in a lower tax bracket when you reach retirement than you are now, then pre-tax would make the most sense. If you think you will be in a higher tax bracket when you reach retirement, then you probably want to favor the Roth option.

What is the problem with that line of thought? People in Washington, D.C. determine federal income tax rates. So, from one election cycle to the following, we don’t know for sure what tax rates will be, let alone what they will be thirty or forty years from now. 

Generally, the younger you are, the more sense the Roth makes for you. There are two primary reasons for this.

• You have more years of tax-free growth.
• Hopefully, at the start of your career, you are in the lowest tax bracket you will ever be in for the rest of your life.

Personally, I am a big fan of giving yourself options and flexibility. For most people, the sweet spot in retirement is to have significant money in both positions. That way, you can take the base of your income from the taxable side of the plan. Then, when you get to the top of the tax bracket you feel comfortable paying, you switch to pulling tax-free income from the Roth side for the rest of the year.

Some of you may already have significant taxable income sources lined up for retirement. These might be large pre-tax retirement balances or perhaps pensions. If that is the scenario, then the Roth might also make sense.

What about a company match or profit sharing? In most cases, company contributions go into the plan on a pre-tax basis.  When your employer matches dollar for dollar, using the Roth feature for salary deferrals up to the cap on the match will provide a balance between pre-tax and Roth. If you defer an amount above the match cap, adjust accordingly.