Question: My retirement plan allows me to choose between pre-tax 401(k) contributions or after-tax Roth contributions. Which is better?
Answer: Your pre-tax 401(k) withholding is saved in a tax-deferred account where it hopefully grows to a larger value in the future. Because no taxes were paid on the funds when you funded it, there will be taxes to pay when the funds are withdrawn later. After-tax Roth type contributions hopefully grow to a larger value tax-free because after tax dollars are used up front when you fund the account. There are no taxes to pay on qualified withdrawals from the Roth account when you withdraw the funds in the future. Here are several factors for you to consider before you decide if pre-tax 401(k) or after-tax Roth contributions are better for you.
Factor 1: Is your tax rate higher right now than it will be when you retire? If you are in a high income tax bracket now, but you think you will pay a lower tax rate when you retire, it is ideal for you to contribute pre-tax money now and let it grow tax-deferred until retirement. If your retirement withdrawals occur while you are actually in a lower tax bracket, then you have made the correct choice. Conversely, if you think your tax bracket will be at a higher level later when you retire you would be better off with making after-tax Roth contributions now. But how can you be in a higher tax bracket in the future if you are no longer employed? Some believe we are currently at an all-time low for tax rates and it is inevitable they will be higher in the future. Those who think that way would consider the Roth contribution now. If your tax rate now is exactly the same at retirement then tax-deferred 401(k) might still be better than tax-free Roth because there will be more pre-tax money to invest up front and the pre-tax deductions are enjoyed up front using your current marginal tax rates.
Factor 2: Will Roth account withdrawals actually be tax free when you are ready to retire? Currently when a person who meets all the retirement criteria withdraws their funds from a Roth account, there is no taxable event. However, nothing involving Congress is safe forever. If you are 30 years old and save Roth funds for 30 years, you are not guaranteed that withdrawals from your Roth fund will still be tax-free 30 years from now. When it comes to paying taxes, you are guaranteed nothing. In this respect there is some inherent risk, if you have a long time horizon to wait for retirement, Congress will likely decide to limit or revise tax-free withdrawals from a Roth. To mitigate this risk, many investment advisors encourage participation in both pre-tax and Roth so the option to withdraw from one or the other account will be available for you in the future.
Factor 3: Is estate planning an issue? Allowing funds to grow tax-free is a pretty exciting concept for people who are looking for somewhere to hold money for a long time. If you would prefer your beneficiaries receive a tax-free asset instead of a taxable asset, the Roth is currently the way to go. An inherited Roth account will continue to grow tax-free for a beneficiary if it is not withdrawn. However, the IRS doesn’t want this money to grow tax-free forever so they will require the beneficiaries to take a distribution from the tax-free Roth account each year until it is gone. The younger the beneficiary, the longer it will take for a total distribution from the inherited tax-free Roth account.
As to which type of withdrawal is best, the answer is different for different people. You could have a completely different best case scenario than your best friend or your parents. Ponder these three factors to help you determine if your money will be better in a pre-tax or a tax-free account when you begin withdrawals during retirement. And then discuss it with a professional to be sure you haven’t missed anything.