The decision between choosing pretax or Roth contributions can be difficult. The benefits vary for everyone, but it is important to know the difference before you decide which one to choose. This guide will go over some of the differences and help you come to a better conclusion about what type of account would work best for your needs.
Pretax vs. Roth contributions: What are the key differences?
It’s possible to make confident, educated judgments about your future by understanding the distinction between pretax contributions and Roth contributions. Compare the two side-by-side:
| Pretax Contributions | Roth Contributions |
|---|---|
| Higher paycheck today in exchange for higher taxes in retirement. | Lower paycheck today in exchange for no taxes in retirement. |
| Lower taxable income today by paying no taxes on retirement contributions now. | Tax-free income in retirement by paying taxes on contributions today. |
| Pay a penalty if you begin withdrawing money before age 59½. | Pay a penalty if you begin withdrawing money before age 59½. |
| Pay taxes in retirement on income from these plans. | Don’t pay taxes in retirement on these plans. |
The employer match for your Roth contributions is considered a pretax contribution since it’s funded with before-tax dollars. You’ll have to pay taxes on that amount when you withdraw it.
What is Roth Deferral?
A Roth deferral is an after-tax contribution, which means you must pay current income tax today on the deferral. Since you have already paid tax on the deferral, you won’t pay tax on it again when you receive a distribution of your Roth deferral.
If you satisfy certain IRS distribution conditions, you won’t have to pay tax on the earnings either. This means that the distribution of the Roth earnings can be tax-free.
Roth Contributions Are Better If:
- In retirement, you anticipate your taxes to be higher. You may save money by paying a lower tax rate on your savings today.
- You have decades to accumulate your funds. You’ll pay taxes on what you put in today, but you won’t on the profits, which may add up over time.
- You’d rather pay taxes now than later. If you’re in your peak earning years, you may be able to afford to pay more taxes right now.
Pretax Contributions Are Better If:
- You believe your income taxes will be lower in retirement. You can save money today by reducing your taxable income now and paying taxes on your savings later when you retire.
- You’d rather save for retirement with a lower percentage of your take-home pay sacrificed.
Can I contribute to both Pretax and Roth plans?
You may be able to make both pretax and Roth contributions if your plan allows it. Diversifying the timing of your tax payments now and in the future might help you balance out any subsequent changes.
After You Leave Your Job
If you leave your job, you may roll your pretax retirement plan balance into an Individual Retirement Account (IRA) or IRA annuity and your Roth money into a Roth IRA or Roth IRA annuity. You may also choose to merge your account with the retirement plan of your next employer.
Benefits of an Annuity
- Tax-advantaged earnings
- A retirement income for life
- Principal protection
- Inflation protection
Does Increasing 401k Contribution Lower Taxes?
Increasing your 401(k) contribution will lower your taxable income today because the money is being set aside for retirement and not in your pocket. However, your taxable income could be higher once you retire in the future.
Related Reading
- What is a Roth IRA, and how does it work?
- Roth 401(k) vs. 401(k)
- Roth IRA Early Withdrawal Penalty
- Roth IRA Taxes
- Roth IRA vs. 403(b)
- After Tax vs. Roth Contributions
- Roth IRA vs. 457 Retirement Plan
- How Much Money To Retire
- My Roth IRA Is Losing Money. How Do I Protect It?
- How Does The Stock Market Affect My 401(k)?