Pre-tax vs. Roth 401(k): Deciding which one to use for retirement is trickier than you think

Whether you’re starting a new job or updating your retirement savings goals, you may have to choose between pretax or Roth 401(k) contributions — and the choice may be more complex than you think.

While pre-tax 401(k) deposits provide upfront tax relief, the funds grow tax-free, which means you’ll have to pay withholdings when you withdraw. In contrast, Roth 401(k) contributions occur after taxes, but your future earnings grow tax-free.

Most plans have both options. According to the Plan Sponsor Council of America, which surveyed more than 550 employers, about 88% of 401(k) plans offered Roth accounts in 2021, nearly double what a decade ago.

While your current and future tax brackets are part of the puzzle, experts say there are other factors to consider.

“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).

One of the big questions to consider is whether you expect to be in a higher or lower tax bracket in retirement, experts say.

Generally speaking, pre-tax contributions are better for high earners because of the upfront tax relief, Lawrence said. But if your tax bracket is lower, it might make sense to pay levies now with Roth deposits.

Lawrence Pon, CFP and certified public accountant at Pon & Associates 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% bracket or lower, I think Roth’s contribution makes sense, assuming you’ll be in a higher bracket in retirement,” he said.

While it’s unclear how Congress can change tax policy, several provisions of the Tax Cuts and Jobs Act of 2017 are set to expire in 2026, including lower tax brackets and a standard deduction. higher.

Experts say these expected changes can also be factored into the analysis of pre-tax contributions versus Roth.

“We’re in this low-tax sweet spot,” said Catherine Valega, CFP and founder of Green Bee Advisory in Boston, referring to the three-year period before tax brackets can increase. “I say taxes are on sale.”

While Roth’s contributions are a “no-brainer” for lower-income youth, she said the current tax environment has also made such deposits more attractive to higher-income clients.

“I have clients who can make $22,500 for three years,” Valega said. “It’s a nice chunk of change that will grow tax-free.”

Additionally, recent Secure 2.0 changes have made Roth 401(k) contributions more attractive to some investors, she said. Plans can now offer Roth employer matches, and Roth 401(k)s no longer require minimum distributions. Of course, plans can vary depending on the features employers choose to adopt.

Lawrence of Goldfinch Wealth Management said “legacy goals” are also a factor when choosing between pretax and Roth contributions. “Estate planning is becoming a bigger part of what people actually think about,” he said.

Since the Secure Act of 2019, tax planning has become trickier for inherited Individual Retirement Accounts. Previously, non-spouse beneficiaries could “stretch” withdrawals throughout their lifetime. But now they have to exhaust inherited IRAs within 10 years, which is called 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 years,” Lawrence said.

However, Roth IRAs can be a “better estate-planning tool” than traditional pre-tax accounts because non-spouse beneficiaries won’t have to pay taxes on withdrawals, he said.

“Everyone has their own preferences,” Lawrence added. “We just try to provide the best options for what they’re trying to accomplish.”