Pre-Tax Vs. Roth Account: Which Is Best For Me?

Posted by Jake Sadler on March 30, 2022

Pre-Tax Vs. Roth Account: Which Is Best For Me?

The concept of “one-size-fits-all” doesn’t apply to saving for retirement. Being financially prepared for your golden years is crucial for many Americans, but the planning process looks different for each individual and couple.

That said, many people take advantage of two types of accounts for retirement savings: pre-tax retirement accounts and/or Roth retirement accounts. If you’re wondering whether a pre-tax vs. a Roth account is the best choice for you, learn more about both options in this article.

Seeking expert retirement planning advice that can also help you leverage tax savings opportunities? Schedule a call with us today to learn about our comprehensive approach to financial planning and taxes.

The Changing Retirement Landscape

Over the past few decades, the responsibility of saving for retirement has shifted dramatically from employers’ to employees’ shoulders. This shift has fundamentally transformed how Americans prepare for the years when they’ll no longer be working. Changes to pension plans (employee benefits that include employer contributions to a pool of money intended for retirement) have largely driven this shift.

The transition from defined benefit pension plans to defined contribution plans has reshaped the face of the retirement landscape. While pension plans used to be commonplace in the private sector, most employers have moved away from them. From 1980 to 2008, nationwide participation in defined benefit pension plans fell from 38% to 20% of the U.S. workforce. In contrast, defined contribution plan participation jumped from 8% to 31%.

Companies are choosing defined contribution plans like 401(k)s over pension plans for several reasons. For example, 401(k)s are less complex and therefore less expensive to manage. They also enable organizations to take on a lower level of risk because they do not have to manage employees’ investments in order to honor their future promise.

In a time when workforce mobility is more important than ever, companies also don’t want to be tied to employees for decades just so they can collect a pension. The same is true of employees, as many workers today do not want to stay with one employer for their entire career. In addition, defined contribution plans offer a greater amount of flexibility for employees to choose how they want to save for retirement.

The changing retirement landscape has ushered in many different ways to save. Depending on your personal financial situation, one method might be a better fit for you than another—for example, a pre-tax vs. Roth IRA account.

Retirement Savings Decisions: What To Consider

The first step on your retirement planning journey includes finding out what savings options are available to you. Not everyone has the same set of choices. Your unique circumstances will likely depend on factors such as your employer, your earnings, and whether you’re eligible to participate in certain types of savings plans.

Your next step is to assess your financial situation. For example, you may have five different savings options A through F available to you, but perhaps only options B, C, and D are appropriate for your situation. The most common option for retirement savings is the 401(k), an employer-sponsored defined contribution plan. This is a type of pre-tax savings account. Another option is a Roth IRA, which is a type of after-tax savings account. We’ll get into the details of both account types next.

Pre-Tax Savings Accounts, Explained

A pre-tax savings account is also known as a tax-deferred or tax-advantaged retirement account. It allows you to deposit money that hasn’t been taxed and invest the funds. You’ll continue to defer paying tax along the way as the money grows. Then, when you withdraw funds from the account, the money will be taxable as ordinary income.

Common Pre-Tax Savings Options

Created in 1978, the 401(k) is a relative newcomer to the American financial system, but it’s highly prevalent in U.S. workplaces today. Most 401(k) plans are pre-tax vs. Roth, which means that all employee earned contributions are not taxed until you withdraw the funds later in life. However, some plans offer both pre-tax and Roth (after-tax) components, adding to the set of choices available to some workers.

401(a) and 403(b) plans are other common types of pre-tax savings accounts. The 403(b) is similar to a 401(k), except it’s designed for nonprofit organizations. Another common option is the traditional IRA, which exists outside the workplace and is a retirement savings account that you can choose to open on your own.

The main benefit for all of these accounts is that they enable you to reduce your taxable income in the year you make contributions. The contribution limits for 401(k) and 403(b) plans are substantial—almost four times higher than traditional IRA contribution limits, depending on whether you've reached age 50 yet.

Keep in mind that under current law both a 401(k) and traditional IRA require you to begin making withdrawals at age 72. These are known as required minimum distributions. So, you will need to start paying the IRS back at some point.

Pro Tip: If you have a workplace-defined contribution plan like a 401(k) with a matching component from your employer, it’s a smart idea to take advantage of the full employer match. You’re entitled to this benefit, and more importantly, it will enable you to get a tax break. It’s a good incentive to save for your golden years; not leveraging the matching component is like leaving money on the table!

Downsides Of Pre-Tax Accounts

If you’re considering a pre-tax retirement savings account, it’s important to know their potential disadvantages:

  • You may have limited account options. When you’re enrolled in a 401(k) plan, it may limit your eligibility to make a deductible contribution to a pre-tax traditional IRA outside of your workplace if your income is above a certain threshold.
  • You may have limited investment choices. With pre-tax workplace plans, you will be limited by the investment choices that those plans offer in terms of the cost, quality, and variety of choices. However, the investment options for 401(k) and similar plans have started to become more diversified, and age-based options are available. In contrast, you can manage your own investment choices if you open a traditional IRA.
  • 401(k) and 403(b) plans carry administrative costs. These fees vary, and while there have been changes over years to how the costs are disclosed to increase transparency, the extra fees are often still not top of mind for people.

Roth IRAs, Explained

A Roth IRA is also a tax-advantaged retirement account. However, in contrast to a pre-tax account, you put money into a Roth IRA that you’ve already paid tax on. The money grows tax-free and remains tax-free forever. Your contributions to a Roth are not tax-deductible. In addition, there are no required minimum distributions associated with Roth IRAs.

A Roth IRA is an ideal retirement savings vehicle if you are currently in a lower tax bracket and don’t have a 401(k) plan. If you’re young, opening a Roth IRA now will give you more time for compounding interest, which will enable you to leverage the account’s tax-free nature.

Downsides Of Roth IRAs

  • Roth IRAs don’t always work well for high earners. If your income is high, you may be earning too much to contribute to a Roth IRA. In 2022 eligibility to contribute to a Roth IRA is reduced, then completely eliminated if your income falls in these thresholds:
    • $129,000 to $144,000 - single taxpayers and heads of household
    • $204,000 to $214,000 - married, filing jointly
    • $0 to $10,000 - married, filing separately
  • You have to wait five years before making tax-free withdrawals. You are permitted to take funds out of the account prior to having it open for five years, but if you do, the money’s growth will be taxed. Distributions prior to age 59 ½ may also be subject to a 10% penalty.

Choosing Between Pre-Tax Vs. Roth Contributions

When making the pre-tax vs. Roth decision for retirement savings, assess your tax rate today as well as what you think it might be in the future. If you expect your tax rate to be higher in the future than it is now, a Roth IRA likely makes the most sense as a savings vehicle. If you expect your tax rate to be lower in the future, a traditional IRA or another kind of pre-tax account is probably your best bet. The best choice also may depend on your age and time until retirement. Generally, the more time you think you will have until retirement, the more favorable the Roth becomes as you have a longer period of time to compound investment growth tax-free.

Choosing the right savings account for you based on an uncertain future is a guessing game. The further away from retirement you are when you make this decision, the more likely it is that you’ll be slightly off base, but that’s okay. The most important thing is simply to get started saving for your future.

At Bay Point Wealth, we can help you make important financial planning decisions like choosing between pre-tax vs. Roth contributions. We’ll create a personalized roadmap for your retirement that takes your financial goals into account and ensures you have enough money to retire comfortably. Schedule a call with us to learn more about our comprehensive approach to financial and tax planning.

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Topics: Financial Planning, Retirement Planning