Preparing for retirement is a major step; often this can be confusing and you may be unsure about where to put your Contributions. There are different ways that participants can contribute to their retirement plan.
There are two types of contributions you can choose from, these are Roth and Pre-tax. It's important to know that these contribution types are the most commonly associated with 401(k) or to other retirement plans and these are sometimes referred to as a ‘salary deferral’.
Differences between Roth and Pre-Tax
The differences between Roth and Pre-Tax is pretty simple as the major difference is the tax treatment.
- Pre-tax: The strategy with Pre-tax is “don't tax me on it now, tax me on it later”. You’ll put money in without paying taxes on it, and you’ll pay taxes when you withdraw the funds after you retire. Your income tax burden for your current year will be reduced, but you’ll be on the hook for taxes later.
- Roth: The strategy with Roth is “pay now, don't pay tax on it later”. You’ll pay income taxes now, and then put that taxed money into the retirement account to invest. Your current year income tax burden won’t change, but you’ll never pay taxes on this money again.
Roth and traditional deferrals are subject to similar contribution and distribution rules.
To understand Roth and Pre-tax a bit more the example below shows a Principle of $200 monthly contribution, growing over 10, 20, 30 and 40 years at a hypothetical growth rate of 7%. Over 40 years the participant contributes $96,000, it could grow to $528,025. Which would you rather pay taxes on $96,000 or $528,025?
In the case of a Roth contribution you would only pay taxes on the amount you contributed which is $96,000, however with the Pre-tax contributions you would pay taxes on the entire $528,025. Even if you are on a lower tax bracket at retirement you may end up paying more in total tax.
If a participant has selected both pre-tax and Roth contributions and is eligible for employer matching, the employer will match accordingly.
What else should you consider?
There are a few factors you may need to consider in order to make an informative choice and make sure what you choose fits your needs.
- Age: The younger you are the longer your time horizon to retirement, the more it tends to favor Roth contributions because you have more years to build earnings which will eventually be withdrawn tax-free. In contrast if you are within 10 years to retirement, you have a short period before withdrawals are made from your account, in which case Pre-tax makes more sense.
- Income Level: Your income level also has a big impact for choosing between Pre-tax and Roth. the higher your level of income, the more it tends to favor pre-tax contribution. In contrast the lower to medium levels of income, can favor Roth contributions. If you start off in a low income level Roth makes sense, however if your income raises later, you can then switch over to Pre-tax.
- Marital Status: Your marital status matters because if you're married and file a joint tax return, you have to consider not just our income but your spouse's income. If you make $30,000 a year, Roth might be the better option, but if your spouse makes $200,000 a year, your combined income on your joined tax return is $230,000 where Pre-tax contribution may be more appropriate because of tax deduction.
- Withdrawal plan in retirement: If you anticipate that you would need the same level in retirement that you have now, making Roth contributions make sense as your tax rate is not anticipated to drop in the retirement years. The benefits associated with Pre-tax contributions assumes that you're in a higher tax rate nw and when you withdraw the money you will be in a lower tax bracket.
- Abnormal income years: It's not uncommon during work years to have abnormal income years where your income ends up significantly higher or lower than it normally is. In these abnormal years it makes sense to change your Pre-tax to Roth.
How do I decide which one to choose?
A thoughtful decision between Roth and Pre-tax contributions can help you take full advantage of those savings. Your advisor is the best person to help you answer questions like:
- When do you plan to retire?
- Do you have a strategy in place towards achieving that plan?
- If you weren't saving for your retirement what would you invest or spend that money on?
- How far are you to retirement?
The most important thing is to remember, there is no right answer. The key is that you are saving, and you are choosing what makes sense for you. Work with your and advisor and choose the plan that works for you!