Should You Contribute To a Pre-Tax or Roth 401(K)?

We often get many questions around this time of year regarding the key differences between a Roth and Pre-Tax (Traditional) 401(k). This is such a great question and an important concept to understand so you can fully maximize your financial and retirement goals. And, there is no better time than the beginning of the year to review your retirement portfolio. So, let’s get started. 

The main difference between the traditional and Roth 401(k) is that with the pre-tax option, you pay the tax on your contributions and the earnings when you withdraw them at retirement at that current tax bracket, whereas with the Roth, you pay the tax on your contributions upfront, but the earnings can be withdrawn tax free. Roth options are becoming more and more common in company 401(k) plans, so don’t be shocked if you see the option during open enrollment season. What’s really great about this option is that the Roth 401(k) has no income limits unlike the Roth IRA, so if your employer offers it, you are good to contribute. As found in a CNBC article and depicted in the chart below, “roughly 86% of 401(k) plans offered a Roth account in 2020, up from 75% in 2019, according to the Plan Sponsor Council of America.”

As this option is becoming more popular and if your employer’s 401(k) includes a Roth option, how do you decide between the two? Typically when deciding between whether to contribute to a Roth and Pre-tax 401(k), you will compare your current tax bracket with what you think it will be in retirement, which will depend on your taxable income and tax rates in retirement. So, if you plan on making more money in retirement or think you will fall in a higher tax bracket than you are currently in now, you should highly consider contributing to a Roth to take advantage of that often sizable tax break. However, if the opposite is true, and your tax bracket will likely be lower in retirement, consider contributing to a traditional 401(k). Keep in mind that if you are unsure or are interested in both, you can contribute to both the Roth and the Pre-Tax. 

Considering Roth options when deciding on your 401(k) and IRA contributions can often be confusing or stressful, yet very important. However, for those wanting to contribute to an Roth, but don’t have the option within their 401(k)s, keep in mind that Roth IRA’s have income limits which can limit your eligibility when you are past a certain income level. Check out this article from the IRS to see if your income qualifies you to contribute to a Roth IRA. For a mathematical breakdown and example between the two, check out our other blog we wrote a few months back. To discuss which route makes the most sense for your retirement savings, send us an email at info@shermanwealth.com or schedule a complimentary 30-minute consultation here. Also, make sure you check with your CPA or tax professional when making this decision to ensure you are fully protected.