Pre-Tax Contributions or Roth Contributions to your Employer 401(k)? Which to Choose.

Congratulations! You just started your first job and even better news; your company offers a 401(k)!  However, your human resources department gives you a sixty-page packet filled with information, and you don’t know where to start.  In this article, we will go over the high points of a traditional 401(k) versus a Roth 401(k) to help you make an informed financial decision. 

Pre-Tax Contributions 

As an employee in 2024, you can contribute $23,000 to a 401(k). If you are 50 years of age and older, you can contribute an additional $7,500 bringing your grand total to $30,500 for the year.  By definition, a pre-tax contribution is a portion of your compensation/wages taken out before income taxes are deducted.  Since the pre-tax contribution comes out of your paycheck immediately, it lowers your taxable income. 

Advantages of Pre-Tax contributions: 

• Reduced taxable income. Depending on your income, making pre-tax contributions can help move you into a lower tax bracket. 

• Tax deferred growth. Your portfolio will grow without being taxed until you withdraw from your 401(k).  

Disadvantages of Pre-Tax Contributions:  

• Withdrawal Needs. In most cases, you are required to wait till age 59 ½ to withdraw your money.  If withdrawn early, you will pay ordinary income tax on that amount with a Federal penalty of 10%, generally.   

• Required Minimum Distributions. The IRS will want some of that money distributed back to you someday.  If you were born after 1959, you are required to take out a certain percentage from the 401(k) annually starting at age 75, which will be taxed as income at the time of withdrawal.  In all cases, pre-tax distributions are taxed as ordinary income. 

Roth Contributions 

When making Roth contributions to your 401(k), the money comes out of your paycheck after taxes.  All contributions grow tax-free after a five-year holding period.  

Advantages of Roth Contributions: 

• Withdrawals. Roth 401(k) earnings can be withdrawn tax free if you are over 59 ½ and have satisfied the five-year holding period.  

• Tax Diversification. Having a Roth allows you freedom to manage your tax situation easily in retirement. The funds were taxed going in, grow tax free and withdraw tax free. Thus, no income taxes are necessary when withdrawing funds.  

• Bye Bye Required Minimum Distributions. Starting in 2024, required minimum distributions are no longer mandatory for Roth 401(k)s.  

• Employer Contributions. The Secure 2.0 Act of 2022 allows employer matching contributions to go to your designated Roth account instead of the pre-tax account.  

 Disadvantages of Roth Contributions: 

• Higher taxes: Missing a tax deferral can be detrimental in certain situations.  Having a lower adjusted income now helps with various adjusted gross income phaseouts applicable to child tax credits, retirement contributions, etc., as well as financial aid for college and federal aid.  Deferrals also lower taxable income for purposes of calculating Federal and State income taxes and capital gains taxes.   
  
  

Tax Timing 

When asking the question of whether to make pre-tax or Roth contributions, the answer comes down to your tax situation.  Understanding your marginal tax bracket and how each dollar earned is taxed helps you navigate how much to contribute to your 401(k).  For example, Joe’s income is $100,000 a year. He contributes $1,000 a month to his 401(k) and is in the 22% Federal tax bracket.  His monthly paycheck reduction would be $780 for a pre-tax contribution. The Roth contribution would reduce his check $1,000.  Alternatively, Betty’s income is $200,000 and is in the 32% Federal tax bracket.  She contributes $1,900 a month to her 401(k).  The reduction for her pre-tax contribution would be $1,292.  Her Roth contribution would reduce her check $1,900.  It might make more sense for Joe to make a Roth contribution since the impact of 22% tax savings on his contribution is much less beneficial than Betty’s 32% tax savings.  The general rule of thumb is to increase your pre-tax contribution percentage the higher your tax bracket increases while the inverse is true for Roth contributions.  When starting a career, you are most likely in a lower tax bracket and more advantageous to make Roth contributions.  

Life events happen and your income varies so your contribution strategy may change on an annual basis.  You just received a large bonus, got married, was laid off or started a new business. Having a flexible strategy can help you efficiently save your money and build wealth. 

Summary 

Every eligible person should participate in their employer sponsored retirement plan since saving for your future is critical to ensure a financially secure retirement.  However, employer plans can be confusing, especially when it comes to setting aside money in your pre-tax plan or Roth 401(k).  Weigh your options and work with your financial advisor deciding which option works best for you with your tax circumstances. 

References: 

Kitces, M. (2017, September 20). To Roth or not to Roth - May 2009 issue of The Kitces report. Nerd’s Eye View | Kitces.com. https://www.kitces.com/to-roth-or-not-to-roth-may-2009-issue-of-the-kitces-report/  

Kitces, M. (2021). Limits of Tax Diversification and the Tax Alpha of Roth Optimization. Limits Of Tax Diversification And The Tax Alpha Of Roth Optimization. 2024, https://www.kitces.com/blog/tax-diversification-roth-optimization-conversion-tax-alpha/  

Retirement plan and IRA required minimum distributions FAQs | Internal Revenue Service. (n.d.). https://www.irs.gov/retirement-plans/retirement-plan-and-ira-required-minimum-distributions-faqs 

Retirement topics - 401(k) and profit-sharing plan contribution limits | Internal Revenue Service. (n.d.). https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits 

Roth comparison chart | Internal Revenue Service. (n.d.). https://www.irs.gov/retirement-plans/roth-comparison-chart 

Disclosures: 

Apella Capital, LLC (“Apella”), DBA Apella Wealth is an investment advisory firm registered with the Securities and Exchange Commission. The firm only transacts business in states where it is properly registered or excluded or exempt from registration requirements. Registration with the SEC or any state securities authority does not imply a certain level of skill or training. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, product or any non-investment-related content made reference to directly or indirectly in this material will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may not be reflective of current opinions or positions. Please note the material is provided for educational and background use only. Diversification seeks to improve performance by spreading your investment dollars into various asset classes to add balance to your portfolio. Using this methodology, however, does not guarantee a profit or protection from loss in a declining market. Past performance does not guarantee future results. All data is from sources believed to be reliable but cannot be guaranteed or warranted.   

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