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Should I make Roth or Pre-Tax Contributions to my Retirement Plan?

Written by: Derek Melvin

When beginning a new job, one of the first action items is going through open enrollment and learning about the benefits package available to you. Typically, you will be bombarded with information regarding your health insurance, vacation/sick leave, among all the other benefits your employer has to offer, leaving not much time to dig into the fine details of your retirement accounts.

With that said, we all know saving for retirement is extremely important, so we need to make sure we are understanding the tax-implications of our retirement contributions to make sure we are saving as tax-efficiently as possible. When I say tax-efficient, that is referring to whether you should be making Roth or pre-tax contributions to your retirement plan.

Please note that not all 401k’s or 403b’s offer the ability to contribute on a Roth (post-tax) or pre-tax basis, however there has been more and more employers as of late offering the option to choose. If you do not see the ability to choose, the default option is pre-tax contributions.

 

Pre-Tax vs. Roth (Post-Tax)

Before we dive into what may be best for your situation, lets first define the differences between Roth (post-tax) contributions and pre-tax contributions.

Family comtemplating roth IRA's versus pre-tax contributions.

What are Pre-Tax Contributions?

Pre-tax retirement account contributions are exactly as they sound. You make contributions before those dollars are taxed. The amount you contribute into your plan for the year is deducted from your taxable income.

Pre-tax example:

Gross Income: $100,000
Pre-Tax Retirement Contributions: $15,000
Taxable Income: $85,000

 

In this example, we see that the taxable income, which is the amount you must pay taxes on for the year, is reduced by the amount you contribute into the plan.

Nice deal, right? Uncle Sam looking out for us here with the ability to lower your taxable income while also saving for retirement.

That said, we all know the famous Benjamin Franklin quote that states, “Nothing is certain except death and taxes”, so we must pay taxes on these contributions at some point.

In retirement when you withdraw these funds, you will pay ordinary income taxes on the amount withdrawn. Therefore, if you withdraw $50,000 from your pre-tax retirement plan, you will include that as earned income for the year and pay ordinary income taxes on that amount.

What are Roth Contributions?

Roth contributions act nearly opposite to pre-tax contributions. Roth contributions are made after-tax, meaning that you do not get a tax deduction for the amount you contribute into the retirement plan. You pay taxes on these dollars before contributing them to your retirement plan. When you go to withdraw these funds in retirement, since you already paid taxes on these contributions, qualified withdrawals are 100% tax-free.

Roth example:

Gross Income: $100,000
Roth Retirement Contributions: $15,000
Taxable Income: $100,000

 

Now, if we are not getting a tax deduction for these contributions, what makes Roth contributions attractive?

The answer is: tax-free growth.

The most important aspect of Roth contributions is that your contributions, as well as all the growth within the account, are withdrawn tax free in retirement. Since you have already paid taxes on these dollars, they are not taxed again. Anything that you withdraw in retirement is 100% tax free.

Researching Roth IRA's versus pre-tax contributions.

Should I Make Pre-Tax Retirement Contributions?

Now, we must decide which makes the most sense for your individual situation.

There are two main considerations when deciding whether Roth or Pre-Tax contributions make sense.

  1. Are you at or near your highest expected income level?
  2. Do you have flexibility in your monthly cash flow?

Let’s start with your expected income level.

If you are at or near your highest earnings potential, that means that you are most likely in the highest marginal tax bracket that you expect to be in moving forward. We also must note that tax rates do change over time, with new administrations and new tax codes being implemented quite frequently. If we are paying taxes at the highest income bracket we expect to ever be in, it probably makes sense to contribute on a pre-tax basis and reduce our taxable income.

Now for flexibility in your monthly cash flow.

When you make pre-tax contributions, you are paying less in taxes today. If you are paying less in taxes today, this results in a higher monthly take home. This is a big consideration to have in mind when making this decision.

If cash flow is tight month to month or you are stock piling cash for a major purchase, such as a new home, it will be important to have as much cash coming in as possible to help meet your goals.

If this sounds like your situation, pre-tax retirement contributions could be appropriate for you. This allows you to continue saving for your future without having as hard of a hit to your cash flow as compared to Roth contributions.

 

Cons of Pre-Tax Contributions

The main downside when it comes to pre-tax contributions is that we do not know what tax rates will be in retirement. As I mentioned above, tax laws change with nearly every new administration that takes office. Not only can that impact tax rates, but geo-political events can also have major impacts on what tax rates are.

In the middle of World War II in the early 1940’s, the highest marginal tax rate was 94%(!!!) That means, for every dollar you earned, you kept 6 cents. This was done to help fund the war efforts. Compared to today, the highest marginal tax bracket is 37%

This shows that you are susceptible to risk as it relates to future tax rates, so it is important to have alternative investment accounts outside of only Pre-Tax contributions.

An article my colleague wrote breaks down the different retirement account options available to individuals and the importance of tax-diversification with investment accounts.

 

Should I Make Roth Contributions?

Let’s revisit the two questions I asked earlier.

  1. Are you at or near your highest expected income level?
  2. Do you have flexibility in your monthly cash flow?

Again, we will start with your expected income level.

If you are not at your highest income level that you expect to be in, Roth contributions can make sense. If this is the case, I assume that you are not in a very high marginal tax bracket. Therefore, it could make sense to pay the tax up front while you are in a lower tax bracket and allow these dollars to grow tax-free into retirement.

I also will make the assumption that is you are not in your highest income earning years, you are probably quite a ways out from retirement, meaning these dollars have more time to stay invested.

This is another key with Roth contributions. The younger you are, the more time you have for these contributions to grow tax-free. These contributions are very attractive for younger investors.

Let’s do another example here to show the power of Roth contributions.

If you make an initial $10,000 contribution into a Roth account, never make another contribution, and the investment returns 7.0% annually for 20-years, this account will have a balance of $38,697 after 20-years.

When you go to withdraw these funds in retirement, it will all be completely tax-free, even that $28,697 of growth in the account.

Now let’s do the same example, but the funds are invested for 30-years. The balance will be $76,123 with all other items the same. This shows how time is a huge factor as well due to our good friend compounding interest.

Now for the question about flexibility in your monthly cash flow.

When you make Roth contributions, you are choosing to paying taxes today. Making Roth contributions will result in a less take home income each month. If there is flexibility in the budget, this shouldn’t be an issue.

 

Cons to Roth Contributions

The main downside to Roth contributions relates to both question number 1 and number 2 listed above.

If you are in a high tax bracket, we probably want to take advantage of the pre-tax contributions to avoid a high tax bill.

With regards to question number 2, if cash flow is tight month to month, not receiving a tax deduction for your Roth contributions can make your take home income lower as compared to pre-tax contributions.

 

Can I Make Roth and Pre-Tax Contributions?

Most of the time, the answer is yes.

When you log into your retirement account website and view your contributions, you should have the option to contribute on both a Roth and pre-tax basis.

Say you want to contribute 10% of your salary to retirement. Most of the time, you have the option to input how much you want going to each. Say 6% Roth and 4% pre-tax or split it 5% and 5%. You can do whatever you prefer here.

By having a mix of Roth and pre-tax dollars, this will give you more flexibility in retirement. This will give you the option to choose which account you withdraw from, to minimize your tax burden.

 

Is my 401k/403b an IRA?

Although these accounts are very similar to Traditional and Roth IRA’s, I focused this article simple on your employer retirement plans, being the 401k and the 403b.

If you would like to learn more about IRA’s and how these can be a great supplemental savings tool to your retirement plan, please view this article breaking down the differences between these.

 

Summary

In conclusion, we all know it is extremely important to save for retirement. Whether it be Roth or pre-tax savings, the most important thing is to actually be putting enough money away to make sure you are on track to meet your retirement goals.

With that said, it is also important to be aware of the tax differences between accounts and how choosing what account to invest your dollars in can have a huge impact on life in retirement as well.

To learn more about financial planning for medical professionals, please visit our website. If you would like to speak with an advisor on what may make the most sense for your situation, please contact us and we would be happy to set up an initial conversation.

 

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Disclosure:

Investing involves the risk of loss, including total loss of principal.  This should not be construed as individualized investing advice.  Consult with your investment advisor to develop an appropriate investment strategy for your circumstances.  This should not be construed as individual tax advice.  Consult with your tax professional for specific tax ramifications for your circumstances. 

 

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