Pre tax vs. Roth 401(k): Deciding which one to use for retirement is trickier than you think

Whether you’re starting a new job or updating your retirement savings goals, you may have to choose between pre-tax contributions or Roth 401(k) — and the choice may be more complicated than you think.

While pre-tax 401(k) deposits offer an upfront tax benefit, the funds are tax-deferred, meaning you owe taxes upon withdrawal. In contrast, Roth 401(k) contributions are made after-tax, but your future earnings become tax-free.

Most plans have both options. According to the Plan Sponsor Council of America, which surveyed more than 550 employers, about 88% of 401(k) plans will offer Roth accounts in 2021, nearly double what they did a decade ago.

While your current and future tax brackets are part of the puzzle, experts say there are other factors to consider.

“It’s hard to broaden the picture because there are so many things that go into making that decision,” says certified financial planner Ashton Lawrence, partner at Goldfinch Wealth Management in Greenville, South Carolina.

Here’s how to decide what’s right for your 401(k).

One of the big questions to consider is whether you expect to be in a higher or lower tax bracket after retirement, experts say.

In general, pretax contributions are better for higher income earners because of the upfront tax benefit, Lawrence said. But if your tax bracket is lower, it may make sense to pay taxes now with Roth deposits.

Lawrence Pon, a CFP and certified public accountant with Pon & Associates in Redwood City, Calif., said Roth 401(k) contributions are typically good for younger employees who expect to earn more later in their careers.

“If you’re in the 22% or 24% bracket or lower, I think the Roth contribution makes sense, assuming you’re in a higher bracket at retirement,” he said.

While it’s unclear how Congress can change tax policy, several provisions of the Tax Cuts and Jobs Act of 2017 will expire in 2026, including lower tax brackets and higher standard deductions.

Experts say these expected changes could also play a role in the analysis of pre-tax contributions versus Roth.

“We’re in this low-tax sweet spot,” said Catherine Valega, a CFP and founder of Green Bee Advisory in Boston, referring to the three-year window before tax brackets might get higher. “I say taxes are for sale.”

While Roth contributions are a “no-brainer” for young, lower-income earners, she said the current tax climate has also made these deposits more attractive to higher-income customers.

“I have clients who can get $22,500 for three years,” Valega said. “That’s a nice chunk of change that will become tax-free.”

In addition, recent changes to Secure 2.0 have made Roth 401(k) contributions more attractive to some investors, she said. Plans can now offer Roth employer matches, and Roth 401(k)s no longer have required minimum distributions. Of course, plans can vary based on the positions employers choose.

Lawrence of Goldfinch Wealth Management said that legacy goals are also a factor in choosing between pre-tax and Roth contributions. “Estate planning is becoming a bigger part of what people actually think about,” he said.

Since the Secure Act of 2019, tax planning has become trickier for inherited individual retirement accounts. Previously, non-spouse beneficiaries could “stretch” withdrawals throughout their lives. But now they must exhaust inherited IRAs within 10 years, known as the “10-year rule.”

The shooting timeline is now “a lot more compact, which can affect the beneficiary, especially if they’re in their prime,” Lawrence said.

However, Roth IRAs can be a “better estate planning tool” than traditional pre-tax accounts because non-spouse beneficiaries don’t owe taxes on withdrawals, he said.

“Everyone has their own preferences,” Lawrence added. “We’re just trying to provide the best options for what they’re trying to achieve.”