Should You Contribute to a Pre-Tax or Roth Retirement Account?: Consider Your Now & Laters
Now & Laters
I have come across possibly nothing more confusing in the personal finance world for my clients than all of the acronyms and terms involved in retirement planning: 401(k), IRA, pre-tax, Roth. It’s enough to make heads spin! Here is a wonderful table I created to help clear up the confusion. Let’s walk it through.
A Quick Background on 401(k) and IRA Accounts:
The most common types of retirement accounts are 401(k)s and Individual Retirement Accounts (IRAs). Both types of accounts are essentially containers for your investments that the government bestows tax advantages on specifically to incentivize us to save for our retirements. They are also what’s called “tax-deferred” - meaning that once the money is in, it grows without being taxed along the way.
401(k) accounts are offered as a benefit from employers, sometimes with contribution matching. They can be offered in both pre-tax and Roth “flavors”. In any given year you can contribute up to $23,000 (in 2024) of salary deferrals (more if you’re over 50) regardless of how much money you make. The catch to get the tax advantages is that you can’t* take the money out before you are 59 ½ (* because there are other rules and caveats here as well). Since you should view this type of account as long-term/retirement money though, that shouldn’t be an issue.
Similar to 401(k)s, there are two types of IRAs each with a different pre-tax or Roth flavor: a traditional IRA (that’s pre-tax) and Roth IRA, and similarly you can’t take the money out until you’re at least 59 ½. Unlike 401(k)s, IRAs are retirement accounts that anyone can open, with or without an employer-sponsored plan. Also unlike 401(k)s, IRA accounts have income limits where if you make more than the given limit you either aren’t allowed to contribute (Roth IRAs) or to take the tax deduction (traditional IRAs). IRAs also have a much lower $7,000 contribution limit (2024) per year.
All 4 of the retirement savings options above are great and even if you can only afford to contribute a small amount each month, it's important to start now. Contributing now allows your money to have time to grow so by the time you reach retirement, you could have a nest egg that will go the distance.
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Even if you don’t resonate with the concept of retirement, it’s important to think about Future You because once you get there, there are no loans for it! You might resonate more with the concept of Financial Independence or Work Optional. The bottom line is that by contributing to these accounts you are giving Future You more flexibility and options, and you’re doing it in a smart, tax-advantaged way!
But which one should I choose: a pre-tax style or a Roth style?
When it comes to planning your finances for retirement, part of the process involves figuring out what kind of retirement account is right for you. We’ve already discussed the most common types of retirement accounts above. But! Regardless of the 401(k) or IRA container choice, should you contribute to the “pre-tax” option or “Roth” option?
A pre-tax account type includes the 401(k) above where you contribute money to the account tax-free NOW (i.e. your employer doesn’t withhold taxes from your paycheck on these contributions, so you effectively only pay tax on a lower income, getting a tax break now) and instead pay taxes only upon distribution later (later being, way later - like in retirement later). This reduces your taxable income in the current year and lowers your overall tax bill. The traditional IRA above acts the same way “pre-tax” - you record what you contribute throughout the year, and then you tell the IRS about your contributions when you file taxes so that your contributions are deducted from your income.
With a Roth Individual Retirement Account or Roth 401(k), you contribute money that has already been taxed. This means that you don’t get a tax break now, but LATER when you withdraw the money in retirement, you won't have to pay any taxes upon distribution (yay!).
You can imagine that while there’s a lot we don’t know about future tax rates, tax brackets, and so on, what you do know about is YOU.
If you’re already in a high tax bracket, a pre-tax 401(k) might be the way to go. In other words, the strategy here is to push as much income into the future and take your tax break NOW.
However, if you imagine earning a larger salary in the future and are in a relatively low tax bracket now, a Roth IRA or Roth 401(k) might be a good idea. Lock in those lower tax rates now and save your tax break for LATER.
If you’re already in a high tax bracket, a pre-tax 401(k) might be the way to go. In other words, the strategy here is to push as much income into the future and take your tax break NOW.
However, if you imagine earning a larger salary in the future and are in a relatively low tax bracket now, a Roth IRA or Roth 401(k) might be a good idea. Lock in those lower tax rates now and save your tax break for LATER.
(Gosh, I love Now & Laters. <3 )
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Before you get too excited or set on one option though, let’s make sure you’re eligible to contribute:
Roth IRA: If you file single and make over $146,000 in a year, you can only contribute a partial amount of the $7,000; if you make over $161,000, you can’t contribute at all. For those married filing jointly, if you make over $230,000 you can only make a partial contribution; if you make over $240,000, you can’t contribute at all. (These are 2024 numbers.) If you make more than these limits, you could consider doing a backdoor Roth IRA (more on that in a future post), but you should first really consider if doing all this work to go Roth vs maxing out your pre-tax options is worth it since you’re (by definition) in a higher top tax bracket.
Traditional IRA: Do you make more than $83,000 (filing single, in 2023)? If you’re already covered by a retirement plan at your work and your answer is yes, you’re not eligible to deduct your traditional IRA contribution. If you’re not covered by a retirement plan at your work, then there’s no income limit and by all means go for it. If you’re married filing jointly, there are different deductibility limits if you or your spouse are covered by a retirement plan at work. While you can technically still contribute to a traditional IRA no matter how much money you make, there’s not as much point if you can’t deduct it in the first place. (Unless you’re doing the backdoor Roth IRA strategy, in which case this is the first step.)
Pre-tax / Roth 401(k): There are no income limits here! And the 401(k) container has a higher maximum allowed contribution than IRAs. It’s generally a good idea to contribute what you can here.
Can I do both?
Yes! Contributing to a 401(k) does not preclude you from also contributing to an IRA (they have totally separate contribution limits!), so you might also contribute to both! For example, one common combination I see is maxing out your pre-tax 401(k) through your employer and then also maxing out a Roth IRA. (Of course, doing this assumes you make less than the Roth IRA income limits and also have the cash flow to do this.
Both types of tax advantages have their uses, so it's important to understand their differences before making a decision. Ultimately, the best retirement saving strategy is the one that fits your personal finance situation and goals. No matter the investment vehicle, taking the time to learn about your options and invest will ensure your money works for you around the clock.
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