Is it better to invest pre-tax or after-tax?
The main advantage of after-tax investing is that it can unlock tax- and penalty-free retirement income. For example, you can tap Roth IRA contributions at any time, free and clear. However, you may be taxed on investment earnings if you've had the account for less than five years and are under 59½.
If you think your tax rate will be lower when you begin taking withdrawals in retirement, traditional contributions may make sense. If your tax rate will be about the same (or higher), Roth contributions might be preferable.
Because they are excluded from gross pay for taxation purposes, pretax deductions reduce taxable income and the amount of money owed to the government. They also lower your Federal Unemployment Tax (FUTA) and state unemployment insurance dues.
Key Takeaways. Given the chance, should you contribute on a pretax basis to a traditional 401(k) or steer after-tax dollars into a Roth 401(k). In general, Roth dollars tend to be worth more because those assets can be withdrawn tax free, whereas the traditional 401(k) dollars have yet to account for taxes.
Pretax contributions may be right for you if:
You'd rather save for retirement with a smaller hit to your take-home pay. You pay less in taxes now when you make pretax contributions, while Roth contributions lower your paycheck even more after taxes are paid.
Should You Split Contributions Between a Roth and Traditional Account? Splitting contributions between a Roth and traditional account can allow you to get some tax benefit today while hedging somewhat against higher tax rates in the future.
Even when you're close to retirement or already in retirement, opening this special retirement savings vehicle can still make sense under some circ*mstances. There is no age limit to open a Roth IRA, but there are income and contribution limits that investors should be aware of before funding one.
The Bottom Line. In a 401(k) vs. Roth IRA matchup, a Roth IRA can be a better choice than a 401(k) retirement plan, as it typically offers more investment options and greater tax benefits. It may be especially useful if you think you'll be in a higher tax bracket later on.
Contributions and earnings in a Roth 401(k) can be withdrawn without paying taxes and penalties if you are at least 59½ and had your account for at least five years. Withdrawals can be made without penalty if you become disabled or by a beneficiary after your death.
Pre-tax contributions can reduce your overall tax burden now, but post-tax benefits can result in tax savings in the future. By working with a tax advisor and staying up to date on pre and post-tax benefits, common deductions, and your state and local taxation laws, you will save time and future headaches.
Are pre-tax benefits worth it?
These pre-tax deductions also provide valuable benefits, such as contributing to retirement plans, life and health insurance, savings accounts for medical expenses, transportation benefits and daycare. Pre-tax deductions are not just a benefit for employees. They benefit employers too.
A key benefit of a pre-tax retirement savings account is the potential to reduce your taxable income today, and not pay taxes until you withdraw your money.
The list of cons may be short for Roth 401(k)s, but missing tax deferral is a big one. When faced with a choice of paying more tax now or later, most people choose to pay later, hence the low participation rates for Roth 401(k)s.
Key Points. About 90% of 401(k) plans now have a Roth feature. Unlike Roth IRAs, Roth 401(k)s don't have income limits. Roth 401(k) employee contributions are limited to $23,000, or $30,500 for those 50 and older, in 2024.
If you expect your tax bracket to increase, the Roth contribution option will clearly make more financial sense. If you predict the reverse, pretax contributions will benefit you more in the long run.
What is a backdoor Roth IRA? A backdoor Roth IRA is a conversion that allows high earners to open a Roth IRA despite IRS-imposed income limits. Basically, you put money you've already paid taxes on in a traditional IRA, then convert your contributed money into a Roth IRA, and you're done.
Yes, once retired or while still working if your plan permits in-service withdrawals from your 401(k). You can convert your traditional 401(k) either through a direct rollover to a Roth IRA or by rolling funds over to a traditional IRA, and then converting to a Roth IRA.
Choosing the Best Option for You
If you expect income tax rates to increase in the future, a Roth 401(k) contribution makes more sense, as it's better to pay the lower income tax rate today and avoid the higher income tax rate in the future when you are taking distributions.
The Best Choice. So, to sum it all up: Your best choice is to invest in your 401(k) up to the employer match and then open up a Roth IRA—and make sure you reach your goal to invest 15% of your gross income in retirement.
Tax diversification: High-income earners often find themselves in higher tax brackets. A Roth 401(k) account gives you more flexibility in managing your tax liability during retirement. Having a Roth account also allows you to be strategic about the tax treatment of your investment choices.
What is the downside of a Roth IRA?
You have to wait longer for the tax-savings payoff with a Roth IRA versus a traditional IRA. You pay taxes on the money before it goes into the account, meaning no tax deduction.
For the most affluent investors, the decision may be moot anyway due to Internal Revenue Service (IRS) income restrictions for Roth accounts. For 2023, individuals can't contribute to a Roth if they earn $153,000 or more per year—or $228,000 or more if they are married and file a joint return.
You can convert a traditional IRA to a Roth no matter your age. But if the conversion boosts your income, it could have taxing consequences. It's not difficult to convert a traditional IRA to a Roth if you mind your taxes. And you can contribute to a traditional IRA at any age as long as you have earned income.
Any Traditional 401(k) assets that are rolled into a Roth IRA are subject to taxes at the time of conversion. You may pay annual fees or other fees for maintaining your Roth IRA at some companies, or you may face higher investing fees, pricing, and expenses than you did with your 401(k).
Good alternatives include traditional and Roth IRAs and health savings accounts (HSAs). A non-retirement investment account can offer higher earnings but your risk may be higher. Investment accounts don't typically come with the same tax advantages as retirement accounts.
