An Age-Old Question: Pre-Tax or Post-Tax Retirement Account Contributions?
When it comes to planning for retirement, understanding the difference between Traditional pre-tax contributions and Roth after-tax contributions is important. "Should I be making Traditional or Roth contributions?" is a very common question on the minds of my clients, and it's a good one. Both options offer distinct advantages, and selecting the right strategy depends on your specific circumstances and financial goals. Let's dig into the characteristics, the benefits, and the considerations for each. Hopefully, these details will assist you in making the right decision regarding your retirement savings.
Traditional Pre-Tax Contributions
Pre-tax contributions refer to the money you contribute to your retirement accounts before taxes are deducted from your income. These contributions are made with pre-tax dollars, meaning they reduce your taxable income in the year of the contribution. By reducing your taxable income, you may enjoy immediate tax savings as your overall tax liability decreases.
Roth After-Tax Contributions
Roth contributions, on the other hand, involve investing after-tax dollars into your retirement accounts. With Roth contributions, you do not receive an immediate tax deduction as the contributions are made with funds that have already been taxed. However, the primary benefit of Roth contributions lies in their tax-free growth potential. If you meet certain requirements, withdrawals from Roth accounts can be made tax-free in retirement.
Common Types of Retirement Accounts with Traditional and Roth Options
Individual Retirement Account (IRA): An investment account designed to help individuals save for their retirement. Most IRAs are not employer-provided plans.
401(k) plan: a retirement savings plan available to employees of for-profit companies.
403(b) plan: a retirement savings plan available to employees of certain tax-exempt organizations like public schools, hospitals, and non-profit organizations.
457(b) plan: a retirement savings plan available to employees of state and local governments and other tax-exempt organizations.
Note that not all employers offer retirement plans, and for those that do, not all of them offer Roth options. Check with your employer or plan administrator for available options.
Contribution limits, rules, and requirements are different for each of these accounts and change from time to time. The IRS offers a nice resource for the details on these accounts at https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-contributions
Factors to Consider
Current and Future Tax Rates: assessing your current tax rate and predicting your future tax rate can help guide your decision between pre-tax and post-tax contributions. If you anticipate being in a higher tax bracket during retirement, Roth contributions may offer greater tax benefits.
Immediate Tax Savings vs. Tax-Free Growth: pre-tax contributions provide upfront tax savings as they lower your taxable income in the present. Roth contributions, however, provide the advantage of tax-free growth and tax-free withdrawals during retirement.
Flexibility and Access: Roth contributions may offer more flexibility in terms of accessing funds before retirement age without penalties. Pre-tax contributions generally have less flexibility.
Required Minimum Distributions (RMDs): pre-tax contributions are subject to RMDs once you reach a specific age, while Roth contributions are not. If you prefer to maintain control over when and how much you withdraw from your retirement accounts, Roth contributions may be a better choice.
The IRS provides a helpful summary chart of Roth vs Traditional accounts with current numbers; it's worth checking out: https://www.irs.gov/retirement-plans/roth-comparison-chart
Which is the Right Choice for You, Pre-Tax versus Post-Tax? Still Not Sure? Consider...
Not choosing and doing both: instead of choosing between traditional pre-tax and Roth post-tax savings, consider splitting your contributions between the two options. This is another form of diversification known as tax diversification. It allows for some measure of tax benefit currently, and in retirement, it allows some flexibility in managing the streams of income and tax liability.
Converting: if you contribute to a Traditional pre-tax account now, perhaps for the reduction in taxable income, you can potentially convert to a Roth in the future, perhaps when your income is lower. If you don't qualify to contribute to a Roth IRA because of income limits, a backdoor Roth IRA contribution may be an opportunity (essentially, you contribute to a Traditional IRA, then convert it to a Roth IRA, losing the deduction on your tax return but gaining tax free growth).
Choosing between pre-tax Traditional and post-tax Roth contributions is an important decision when planning for retirement. Understanding the characteristics and advantages of each option is essential to making an informed choice. Factors such as current and future tax rates, immediate tax savings versus tax-free growth, flexibility of access, and required minimum distributions should all be considered when determining the best strategy for your unique circumstances. By carefully evaluating these factors, you can maximize the benefits of your retirement savings and work towards a financially secure future. Talk with a financial planner or tax advisor to determine the best pre- and post-tax retirement account strategy for your financial situation.
My name is Tim Melia, and I am a CERTIFIED FINANCIAL PLANNER™ Professional. I would be happy to answer any questions you may have or discuss how this topic impacts your life and financial goals. Feel free to email me at tim.melia@emboldenfp.com. If you would like to learn more about working with Embolden Financial Planning LLC, please schedule a free, virtual introductory meeting.
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References
“Retirement Topics - Contributions | Internal Revenue Service.” Retirement Topics - Contributions | Internal Revenue Service, www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-contributions.
“Roth Comparison Chart | Internal Revenue Service.” Roth Comparison Chart | Internal Revenue Service, www.irs.gov/retirement-plans/roth-comparison-chart.
“Retirement Plans FAQs on Designated Roth Accounts | Internal Revenue Service.” Retirement Plans FAQs on Designated Roth Accounts | Internal Revenue Service, www.irs.gov/retirement-plans/retirement-plans-faqs-on-designated-roth-accounts.
