Pre-Tax vs. Roth Savings: What’s the Difference?
When it comes to saving for retirement, you have most likely been presented with the option to contribute pre-tax or Roth. Whether it’s your 401k at work or choosing between a Traditional or Roth IRA, most retirement accounts offer both methods of saving. So, what’s the difference? And more importantly, which method should you choose?
In this piece, we explain the difference between contributing to a pre-tax versus Roth retirement account and what factors you should consider when deciding which method is right for you.
To put it simply, a pre-tax contribution means you save on taxes now and pay taxes later.
With a Roth contribution, it’s the opposite: you pay taxes now and save on taxes later.
Let’s look at a simple example.
Let’s say you make a $100,000 salary, are in the 24% income tax bracket, and want to save $5,000 for retirement.
Pre-Tax Contribution
If you choose to contribute pre-tax to a Traditional IRA, $5,000 will be deducted from your taxable income in the year of contribution, and you will only owe taxes on $95,000. That is $1,200 in tax savings.
Fast forward to retirement. The $5,000 has grown to $50,000 and you are ready to take the money out. What will you pay taxes on?
The full $50,000 as ordinary income.
Since you will likely have reduced income in retirement, let’s assume your income tax bracket drops to 22%. When all is said and done, that means you will pay $11,000 in taxes.
Roth Contribution
What if you choose to contribute to a Roth IRA? You will contribute $5,000 of after-tax dollars, not take any tax deduction, and will pay income tax in the year of contribution on your fully salary of $100,000. That means you will pay $1,200 in taxes on the $5,000 contribution now.
By the time you retire, it grows to $50,000. When you are ready to take the money out of your account, what will you pay taxes on?
Zero dollars.
In the Roth scenario, you will have paid $1,200 when all is said and done.
It may seem from this example that going with the Roth is a no-brainer, but experts point out that if you had invested the $1,200 tax savings from the pre-tax scenario, it would have grown to about the same amount as your final tax payment (thereby offsetting each other). So theoretically, the tax advantages between the pre-tax and Roth savings are about the same.
There are also scenarios where pre-tax contributions may be more suitable. The main reasons are:
You are not eligible to contribute to a Roth IRA
You expect to be in a much lower income tax bracket in retirement
You expect tax rates to be lower in the future
You need a tax deduction for the current tax year
Most workplace plans like 401k or 403b offer Roth contributions as an option, and there are no restrictions on who may participate. Bear in mind however that employer match contributions are often based on employee pre-tax contributions, in which case we would suggest splitting your contributions between pre-tax and Roth so that you get the full employer match. Once you retire, you can rollover your pre-tax balance to a pre-tax IRA and your Roth balances to a Roth IRA.
Roth IRAs on the other hand have an income limit on who may contribute. You must make less than the IRS caps to contribute to a Roth IRA. For 2022, this means gross income must be less than $129,000 for single filers or $204,000 for those who are married filing jointly. Certain high-income earners may take advantage of the back door Roth contribution, but they must also meet certain criteria.
While it’s logical to expect your tax rate to be significantly lower in retirement, we have found that this assumption may not always hold true. For some retirees, their income in retirement is almost as high as it was in their working years after taking into account Social Security income, pension benefits, IRA distributions, and investment income. It may make sense to do some careful planning to project your income in retirement.
In addition, economists/experts generally expect income tax rates to be higher in the future. For example, we are currently enjoying reduced tax rates from the Trump Tax Cuts and Jobs Act in 2017. If Congress does nothing, these lower rates are due to expire at the end of 2025 and return to pre-2018 rates. See a comparison here: https://heritageinvestment.com/wp-content/uploads/2018/01/TCJA-HIG-Old-vs.-New-Comparison.pdf
From working with retirees in our practice, we can tell you that having Roth IRAs in retirement is a big deal. In addition to offering tax-free withdrawals, the Roth IRA has three other advantages:
You can withdraw your contributions (principal) from a Roth IRA at anytime tax- and penalty-free. Roth IRAs (but not Roth 401k) allow savers to withdraw their contribution dollars anytime without tax or penalty. We discourage our clients from taking money out of their retirement accounts prematurely but having this option built into the Roth IRA is a nice feature.
You are not forced to take withdrawals in retirement. For any pre-tax retirement accounts, the government requires you to start taking taxable distributions at age 72. These required minimum distributions (RMDs) tend to start at about 4% and go up with age. With a Roth IRA, there is no RMD which means your savings can enjoy the benefits of compounding for longer.
It’s a better asset to leave to your heirs. Your children or grandchildren who inherit your remaining pre-tax assets will have to pay income tax on their withdrawals and empty the account within 10 years of your death. Roth IRAs also have to be emptied within 10 years, but your beneficiaries will not owe any taxes on their withdrawals. Can you guess which account type your beneficiaries would rather inherit?
Copyright 2022 Lange Financial Group, LLC
In conclusion, our models suggest that while the tax advantages between pre-tax and Roth savings are comparable, Roth accounts offer the added benefit of extended tax-free growth in retirement and as a legacy asset. So, what if you have only built up pre-tax retirement assets in your workplace plan or IRA? There is another technique that allows savers to convert pre-tax dollars to Roth dollars, which may make sense for you. We will tackle this in a future post.
If you have any questions or would like to discuss this topic further, please do not hesitate to contact us at team@jsopartners.com
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