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Eight Considerations When Deciding on Pre-Tax or Roth Contributions

The most important decision you will make in retirement planning is the decision to contribute to your company plan, and to do so in an amount that will allow you to meet your retirement income needs. Deciding between pre-tax or Roth contributions can be difficult and confusing, though.  Sometimes when talking with retirement plan participants, I find they are not sure where to begin and, sometimes are even fearful of making the wrong decision.  There really is no wrong decision to make; and, any decision need not be permanent. Almost all plans allow you to change between Roth and pre-tax or even split your contributions between the two options and then make changes in the future, if desired.   

Let’s take a look at some of the main differences between pre-tax and Roth contributions:

 Pre-Tax Roth

Tax Status

Pre-Tax, meaning any contributions made now are made to the plan before federal income tax has been withheld Post-Tax, meaning that any Roth contributions made now are made to the plan after federal income tax has been withheld

Effect on Current Year 

Reduces your current year Federal Income Tax Does not reduce your current year Federal Income Tax

Effect on Distributions 

Any pre-tax money distributed is taxable income  Assuming your distributions are qualified, then any Roth money distributed is tax-free

* Qualified Roth Distributions are distributions after age 59.5 and after the Roth account has been opened for at least 5 years.  If Roth distributions are not qualified, then the earnings on the Roth money are subject to taxation.

Now, let’s consider some of the traditional rules of thumb for making the Pre-Tax vs. Roth decision:


 Pre-Tax Roth  Explanation
Age Older  Younger  One of the benefits of Roth is that qualified distributions from Roth sources are totally tax-free. This means that both the contributions themselves (or basis) plus the investment earnings on that basis would be tax-free when distributed.  The longer Roth contributions have to grow, the more powerful that benefit is! 
Income  Higher  Lower  Individuals (or households) with higher incomes will be in higher tax brackets in the current year.  The higher the current year tax rate is, the more powerful the immediate tax benefit of pre-tax deferrals is.
Number of Children  Fewer  More  Children are great for many reasons and one of them is driving down your effective tax rate.  If your current effective tax rate is low because you have many children (or for any other reason), it is a good idea to contribute on a Roth basis so you can pay the tax bill now, while the rate is low, and enjoy avoiding taxes later, when your rate (or rates in general) may be higher.
Projected Retirement Income Lower   Higher  Many American workers see a significant drop-off in taxable income when they enter retirement.  As a result, they may end up in a lower tax bracket, making pre-tax contributions more attractive (save taxes while working, pay when retired).  However, if you expect your income in retirement to be about the same or even higher, Roth may make the most sense.
Retirement Income Sources Mostly after-tax sources   Mostly taxable sources  If most of your income in retirement will come from after-tax or Roth sources, then you may expect taxable income to drop significantly in retirement making pre-tax contributions attractive now.  On the other hand, if your income in retirement will come primarily from taxable sources (pensions, Social Security, pre-tax qualified accounts), then having some Roth money will help by providing your portfolio with tax diversification.
Sensitivity to reduced net pay High  Low  Saving on a pre-tax basis has immediate tax benefits, including reduced payroll withholding as contributions are withheld from your pay.  So, if you start contributing 10% to your plan on a pre-tax basis, your net pay will decrease by less than 10% because of reduced federal income tax withholding.

Need for after-tax money after age 59.5 / in retirement 

Low  High  If you anticipate that any large expenses will occur within a single tax year as you enter your 60s or retire, contributing on a Roth basis to help cover those expenses may make some sense.  If your only option for covering large expenses in a single tax year is pre-tax money, then you may put yourself in a higher tax bracket and pay too much in federal income taxes. 

Expectations for future tax rates 

They will go down  They will go up  If you anticipate that the tax rates themselves may be higher in future years as you are drawing from your account to fund your retirement, paying the tax bill now by making Roth contributions may make sense.


Frequently Asked Questions

If I defer on a Roth basis to my 401(k) plan, does that mean I need to open a separate Roth account somewhere?
No, it does not.  Roth deferrals add to your existing balance in your current 401(k) plan; there is no need to open a separate account.  While the Roth money will be tracked and accounted for separately, it is all held within the same plan and typically is invested in the same manner as any other contributions to the plan.

Am I still eligible for employer matching contributions if I switch from pre-tax to Roth contributions?
Yes.  Whether you defer on a pre-tax or Roth basis, if your plan has a matching formula that it follows, your contributions will be matched even if they are made on a Roth basis. Keep in mind that employer matching contributions are taxable income when distributed, regardless of the type of employee contribution being matched.

If I meet the income requirements, am I still eligible for the Retirement Saver’s Tax Credit if I contribute on a Roth basis?
Yes, if you meet the income requirements, you will still be eligible to claim the Retirement Saver’s Tax Credit based on your Roth contributions to the plan.  While pre-tax deferrals themselves help to reduce your Adjusted Gross Income (AGI) to help you qualify for the credit, Roth deferrals will not.  So, if you are close to one of the thresholds, you would want to take this into account or talk with your tax advisor about the change prior to making it.  In 2018, married tax filers who file jointly would qualify for the credit if they made qualifying retirement contributions and their household AGI was below $63,000.

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