How to decide on between pre-tax and Roth 401(ok) contributions

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

While pre-tax 401(k) deposits provide an upfront tax benefit, the funds grow tax-exempt, meaning you owe duties when you withdraw them. In contrast, Roth 401(k) contributions are post-tax, but your future income grows tax-free.

Most plans have both options. About 88% of 401(k) plans were offering Roth accounts in 2021, nearly double the number a decade ago, according to the Plan Sponsor Council of America, which surveyed more than 550 employers.

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

“It’s hard to generalize because so many things go into this decision,” said certified financial planner Ashton Lawrence, partner at Goldfinch Wealth Management in Greenville, South Carolina.

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

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Compare your current and future tax brackets

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

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

If you’re in the 22% or 24% category or below, I think the Roth contribution makes sense, assuming you’ll be in a higher bracket when you retire.

Lawrence Pon

Chartered Accountant with Pon & Associates

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

“If you’re in the 22 percent or 24 percent category or below, I think the Roth contribution makes sense, assuming you’re going to be in a higher bracket when you retire,” he said.

“Taxes are for sale” by 2025

While it’s unclear how Congress might change tax policy, several provisions of the Tax Cuts and Jobs Act of 2017 are scheduled to expire in 2026, including lower tax brackets and a higher standard deduction.

Experts say these expected changes can also feed into the analysis of pre-tax vs. Roth contributions.

“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 period before tax brackets may go higher. “I say taxes are for sale.”

We’re in that low-tax sweet spot.

Catherine Walega

Founder of Green Bee Advisory

While Roth contributions are a no-brainer for young low-income earners, she said the current tax environment 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 pretty nice chunk of change that will grow tax-free.”

Also, recent Secure 2.0 changes have made Roth 401(k) listings more attractive to some investors, she said. Plans can now offer Roth Employer Matches, and Roth 401(k)s no longer have required payouts. Of course, plans can vary depending on what roles employers want to fill.

Many investors also consider “legacy goals.”

Goldfinch Wealth Management’s Lawrence said that “old targets” are also a factor in deciding 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 for inherited individual retirement accounts has become more difficult. Previously, non-spoused beneficiaries could “stretch” payouts over their lifetime. But now they must exhaust inherited IRAs within 10 years, known as the “10-year rule.”

The payout schedule is now “much more compact, which can impact the beneficiary, especially if they’re in their highest-income years,” Lawrence said.

However, Roth IRAs may be a “better estate planning tool” than traditional pre-tax accounts because non-spousal beneficiaries owe no taxes on withdrawals, he said.

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