When deferring to an employer-sponsored plan, such as a 401(k), 403(b), or even a governmental 457 plan, most employees generally have two alternatives: (1) Pre-tax account (a.k.a. “traditional” option), and (2) Designated Roth account.
Both have their pros and cons, yet employees continue to ask the question: “Which one is better for me?”
And the answer is… it depends.
Employees with both pre-tax and Roth options in their employer’s retirement plan have the freedom to decide WHEN they intend to pay taxes (now vs. later).
The Basics
Before diving into the specifics, it’s helpful to lay out the basics of how the two deferral types differ:
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- Pre-Tax: The upfront benefit of federal and state income tax deduction on any deferrals made, up to the IRS deferral limit (plus catch-up contribution limit for anyone 50 or older). Deferrals and earnings grow tax-deferred, whereas withdrawals are taxed as income.
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- Roth: Federal and state income taxes are paid upfront on any deferrals. Roth deferrals grow tax-free and are withdrawn tax-free. Roth earnings are withdrawn tax-free as long as they’ve been in the account for at least 5 years; if withdrawn any time before then, they are subject to taxes.
For those with both pre-tax and Roth alternatives in their workplace retirement plan, there is some freedom of choice around controlling the timing of paying income taxes on retirement assets.
It’s the after-tax dollars that count
With retirement savings, after-tax dollars matter. Why? Because that’s what is left over once taxes are paid.
This begs the question, “Would a person rather end up with more money, or less money, in their retirement account?” More, of course!
Whether one will fare better by using pre-tax or Roth deferrals depends on several inputs. Arguably, one of the most prevalent inputs is what future taxes will be, which is unpredictable.
Assuming that future taxes will increase makes a solid case for making Roth deferrals. However, many employees opt for pre-tax deferrals based on the notion that they’ll end up in a lower tax bracket when withdrawing their money.
Why are pre-tax deferrals more common among employees?
Pre-tax deferrals originated in 1978, whereas designated Roth accounts didn’t even exist until 2006. This could explain in part why many savers make pre-tax deferrals.
To add, there are plan sponsors that still don’t offer a designated Roth option within their company’s retirement plan. Consequently, unless their employees qualify to contribute to a Roth IRA, they don’t have any other option but to make pre-tax deferrals.
A growing number of plans have adopted automatic enrollment provisions, through which automatic deferrals are generally placed into a pre-tax account. While many plans with automatic enrollment also have a Roth provision, the tendency for those automatically enrolled is not to take any action, which is why most individuals remain invested in the plan’s default deferral type.
Many plan sponsors continue to amend their plans to include a designated Roth option, and it is now possible to have automatic deferrals directed into Roth.
Some Unknown Factoids About Roth
Roth has been around since 1997, thanks to the work of the late U.S. Senator William Roth (hence the namesake), who co-sponsored the law that enacted the Roth IRA. In 2006, the tax code was expanded to allow for Roth elective deferrals into qualified retirement plans such as 401(k) and 403(b).
Although a growing number of qualified plans now have a designated Roth option available to employees, many employees assume that they aren’t eligible to defer into the Roth portion of their plan, based on what they know about Roth IRA and income phase-outs. Unbeknownst to many, the phase-outs apply to Roth IRAs, but no such rule exists within qualified retirement plans. This means that anyone with a designated Roth option within their workplace retirement plan can opt to use it, regardless of their household income.
As it relates to catch-up contributions, starting in 2025, as a result of SECURE 2.0, those 50 years of age or older making at least $145,000 in adjusted gross income annually can only make the catch-up deferral to a designated Roth account.1
The Argument for Pre-Tax
This isn’t an exhaustive list by any means, but below are some common reasons as to why some employees may opt to make pre-tax deferrals:
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- Upfront tax deduction: Every dollar deferred is income tax-deductible at the federal and if applicable, state level. This reduces taxable income for that tax year, meaning that there’s more take-home pay relative to what would have been the case, had that money been deferred into a designated Roth account. Roth doesn’t come with deductions; hence why deferrals won’t reduce taxable income in the current year.
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- Lower anticipated tax bracket in retirement: A major argument for using pre-tax deferrals is that one’s taxes will be lower in retirement than during their earning years. Since many will have more limited expenses in their retirement years, their income needs may not be as high, which is often why one ends up in a lower marginal tax bracket.
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- Potential current year tax savings for higher income earners: This isn’t true for everyone, though with higher earnings come higher marginal tax brackets. Generally speaking, deductions can often be the difference maker between eclipsing into a higher tax bracket in any given year.
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- Current cash flow needs: If someone has short-term cash flow needs (e.g. covering basic living expenses), pre-tax deferrals are often preferable, since they allow for higher current disposable income than Roth.
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- Roth deferrals aren’t matched: This is not the norm, but some employers still only match pre-tax deferrals. Employees should not leave any match dollars on the table in such an instance, so may have to defer pre-tax (at least to get the full match). However, many plans match on both pre-tax and Roth deferrals, so this may be a non-factor.
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- No other tax deductions: If someone doesn’t have any other income tax deductions – e.g. student loan interest, mortgage interest – pre-tax deferrals will reduce current-year income, not only resulting in more take-home pay but potentially in a lower marginal tax bracket.
The Argument for Roth
This is also a non-exhaustive list, but below are some common reasons why some employees may opt to make Roth elective deferrals:
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- An expectation that taxes will increase in the future: Assuming that future taxes will increase, there’s a more compelling argument for Roth now, since income taxes paid now will be less than income taxes paid later.
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- Higher anticipated tax bracket in retirement: Some may expect to be in a higher tax bracket in retirement than during their earning years. This is why many employees will forgo the upfront tax deduction now and opt to make Roth elective deferrals.
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- Young and in a low tax bracket: The younger someone is, the more time their retirement dollars will have to grow over time. With Roth, those funds will grow tax-free. Investment performance isn’t guaranteed, though the longer money has to grow, the higher a balance one may have at retirement. And with Roth, the funds come out tax-free.
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- Future earnings are expected to increase: An expected salary increase may ultimately push someone into a higher marginal tax bracket. Until that happens, Roth elective deferrals may provide an opportunity to put after-tax money away while in the lower tax bracket.
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- The psychological impact of paying taxes: There could be saver’s remorse when someone sees a chunk of their retirement assets taken for taxes. This is often the case when money is invested pre-tax. The same could be said for foregoing a tax deduction in the short term, but when making Roth deferrals, the upside comes with not having to pay taxes later on.
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- No required minimum distribution on Roth elective deferrals: Beginning at Age 72 for those who turned age 72 before the end of 2022, and Age 73 otherwise, the IRS requires that a “required minimum distribution” (RMD), be taken from certain qualified retirement plan accounts and IRAs. Starting in 2024, no RMD exists for designated Roth accounts.
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- Qualified distributions are withdrawn tax-free: When taking a qualified distribution, Roth deferrals come out tax-free, and the same holds for Roth earnings if they’ve been in the account for at least 5 years from the date of opening. Pre-tax deferrals and earnings are taxed when withdrawn.
What about employer contributions?
An employer may contribute or even match deferrals into a qualified retirement plan. Employer contributions are made on a pre-tax basis since they allow employers a business tax deduction. So, even if someone defers all of their money into a designated Roth account and their employer matches on those deferrals, that person will still end up with some pre-tax money.
Is there a clear winner between pre-tax and Roth?
There’s a clear advantage to deferring into a designated Roth account if it makes fiscal sense for someone to do so. It is compelling for many to have their retirement funds grow and come out tax-free. Assuming that future taxes will rise, this makes it an even more compelling argument, especially if that’s what ends up happening. This can be especially true for those who are early on in their careers and have a long trajectory ahead of themselves professionally.
How someone decides to defer to their workplace retirement plan – whether pre-tax, Roth, or both – is completely up to them and a decision that should be based on their unique circumstances.
And just because an employee opts to defer into pre-tax now, this doesn’t mean that they can’t change course years later. For example, I used pre-tax deferrals for much of my career as it made sense from an earnings standpoint, and when I turned 40, I started deferring all of my funds into Roth. In hindsight, I would have started deferring to Roth earlier, but as the saying goes, it’s never too late to start something new (which in my case was starting to make Roth elective deferrals when I turned 40).
Irrespective of how one opts to defer their funds, the fact is, that their retirement assets will have the opportunity to increase in value over a long horizon.
What about deferring to both pre-tax and Roth?
It is possible to “double dip” and make both pre-tax and Roth elective deferrals into a qualified retirement plan, such as a 401(k). The caveat is that both are subject to the same IRS limit on deferrals, which for 2024, is $23,000 (plus another $7,500 for those who are 50 or turning 50 this year). Thus, one can make both types of deferrals into the same plan, but the aggregate between the two cannot exceed the IRS limit.
Also, making both pre-tax and Roth elective deferrals allows for greater tax diversification when making future withdrawals.
Summing it all up
Time and time again, plan participants ask me the question “Pre-tax or Roth? What’s better for me?”
And while I wasn’t in a position to render advice, the truth is, the answer is different for everyone.
Just as I did in my situation, I suggest that individuals who ask this question consult with a financial professional, such as a financial planner or even a tax accountant.
For those who may not have access to an advisor, the next step would be to reach out to their plan’s financial advisor. Such professionals may be able to provide proper guidance as to what may be most suitable for someone’s situation, whether that’s deferring all funds into a pre-tax account, a designated Roth account, or a combination thereof.
Many recordkeeper and bank websites, as well as financial wellness websites, have financial calculators that employees can access for free. Many of these calculators compare pre-tax and Roth elective deferrals. As with any online tools, these calculators provide estimates and come with imperfections.
The decision on whether to use or allocate between pre-tax and Roth is an important one and can help to achieve additional after-tax income long-term, though taking steps to ensure sufficient retirement savings is even more crucial.
According to the U.S. Department of Labor, savers should aim to have 70 to 90 percent of their pre-retirement income2 if the intent is to maintain a similar standard of living in retirement. As to how to arrive at this level of pre-retirement income, there are many recommendations as to what to save annually, though this can also depend on several factors, such as one’s age, expected years until retirement, life expectancy, account balance, etc. Fidelity suggests a minimum of 15% annually.3
At the end of the day, achieving retirement readiness is about taking a disciplined and purposeful approach to savings. This means:
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- Determining the amount or percentage of pay to save annually, coming up with an optimal allocation of pre-tax and Roth deferrals, and selecting suitable investments
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- Implementing the above strategy
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- Adjusting that strategy as needed
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