Pre-Tax 401(k) or Roth 401(k) Contributions: What Should I Do?

by IFA Retirement Study - Friday, 12 January, 2018

Definitions:

Pre-Tax 401(k) Contributions: Contributions are made before income taxes are taken out. Participants enjoy tax-deferred growth on their contributions, but will pay income taxes on disbursements in retirement.

Roth 401(k) Contributions: Contributions are made after income taxes are taken out. Participants will enjoy tax-deferred growth of their contributions and disbursements in retirement are tax-free.

Example:

Jane Smith earns $75,000 per year and wants to contribute 10% of each paycheck ($288) to her 401(k). Her marginal federal income tax rate is 25%. If she decides to make pre-tax contributions to her 401(k), she will forgo paying taxes on contributions and $288 will be deposited into her 401(k) each pay period. On the other hand, if she decides to make Roth contributions, she will have 25% deducted from each contribution for income taxes and $216 will be deposited into her 401(k) each pay period.

 

Which is Better?...It Depends!

If Jane’s marginal federal income tax rate does not change over her working life and into retirement, then it doesn’t matter which election she makes in terms of her contributions. Here is why:

Let’s assume Jane contributes $288 each pay period for 30 years and earns an 8% rate of return. If she makes pre-tax contributions, her ending balance in 30 years will be $406,311 on a pre-tax basis. Its after-tax value would be $304,740 after paying $101,571 in income taxes (25%).

If she instead made Roth contributions (after-tax), her ending balance would be $304,740 on an after-tax basis. Notice how each scenario winds up with the same after-tax value, so Jane could of done either and end up in the same exact place in retirement.

 

 

General Rules

  • Pre-tax contributions may make sense for investors who expect to be in a lower tax bracket in retirement compared to today. You forgo paying income taxes on contributions at the higher rate now and pay taxes on disbursement at the lower rate in retirement.
  • Roth contributions (after-tax) may make sense for investors who expect to be in a higher tax bracket in retirement compared to today. You pay income taxes on contributions now at the lower rate and forgo paying taxes on disbursement in retirement at the higher rate.
  • If you expect to be in about the same tax bracket now versus in retirement, then you can diversify your tax exposure and do a little bit of both.

 

Quick Facts:

  • You can save in a Roth 401(k), a pre-tax 401(k), or a combination of both as long as you stay under the total contribution limit for the year ($18,000 or $24,000 if age 50 or older)
  • Investment options are consistent across both Roth 401(k) and pre-tax 401(k).
  • If you rollover your Roth 401(k) to a Roth IRA at retirement, you can forgo required minimum distributions (RMDs) that are associated with pre-tax 401(k)s, Traditional IRAs, or Rollover IRAs.
  • When you leave the company, you can rollover your Roth 401(k) to another Roth 401(k) if your new employer offers one or a Roth IRA. Similarly, you can rollover your pre-tax 401(k) to your new employer’s 401(k) or a Rollover IRA.

 

 

Contact your Fiduciary Plan Advisor,  should you have any questions regarding your employer-sponsored 401(k) retirement plan at 888-643-3133