Pre-tax vs. Roth 401(k): Which is best for you?
Executive Summary
If you are making 401(k) contributions, you have probably wondered which one is better: Roth or Pre-tax (Traditional). It isn’t an easy decision and the names of each account don’t provide much clarity. A Roth contribution is a contribution to a 401(k) after taxes have been withheld. A Pre-tax contribution is a contribution before any taxes are withheld. The rule of thumb is to choose pre-tax (Traditional) if you expect your tax rates to be lower in the future and Roth if you expect your tax rates to be higher in the future.
It is your first day working at a new law firm. You see your new work computer as you sit down at your desk, ready to work. The first few days fill up with training modules and onboarding meetings. One of those meetings is your HR meeting. How cool is this!? You are a lawyer who barely even started working yet your firm is already giving you benefits.
The HR professional walks through all of your insurance options and gets to your 401(k) plan.
“We also offer you a 401(k) that you can contribute to.”
Maybe they will mention an employer match too. But then they move on to the next benefit.
That is not very helpful when you sign up for your 401(k) and you are asked, “How much would you like to contribute to your Pre-Tax (or Traditional) 401(k) and Roth 401(k)?”
Neither term is very helpful in picking which one is right for you. Here are a few common questions that people have:
What are pre-tax and Roth 401(k)'s? How are they different?
Both pre-tax and Roth 401(k)'s are funded with contributions that are pulled directly from your paycheck and deposited into the type of 401(k) that you select. Both limit your total employee payroll contributions to $19,500 in 2021. Meaning you cannot contribute $19,500 to both a pre-tax (Traditional) 401(k) and a Roth 401(k).
These contributions (and any employer matches) will be invested based on your investment selections. Your investment options are the same for both types of 401(k)'s and are limited to those investments offered by the 401(k) plan.
A pre-tax (or Traditional) 401(k) allows you to contribute using money from your paycheck without paying taxes on that income.
A Roth 401(k) takes payroll contributions that are included in your annual taxable income.
To demonstrate how taxes affect contributions, I will use an overly simple example.
Example: Laura the Lawyer makes $100,000 in a state with no state income taxes. Her 2021 federal income tax rate is 24%. She will owe $24,000 in taxes on her income. In addition to her tax obligation, Laura needs $66,000 to afford her lifestyle. Leaving her with $10,000 of taxable income to save for retirement. She could contribute:
Pre-tax (Traditional) 401(k): $10,000
Roth 401(k): $10,000
When Laura the Lawyer contributes to her Pre-tax 401(k), she will deduct her contribution amount from her taxable income. So in Laura’s example, a $10,000 pre-tax (Traditional) contribution reduces her taxable income from $100,000 to $90,000. Instead of owing $24,000 of income taxes, her tax obligation with pre-tax contributions is $21,600 ($90,000 * 24%). This extra $2,400 in tax savings is money that Laura can spend or save.
If she contributes to a Roth 401(k), then she must pay taxes on the entire $100,000 of income she earned. She puts in $10,000 like the pre-tax (Traditional) 401(k), but she would not receive $2,400 of extra money in tax savings.
But how contributions are taxed initially is only half of the consideration when determining whether to contribute to a pre-tax (Traditional) 401(k) or a Roth 401(k).
We also have to consider how these accounts are taxed when we withdraw the money in retirement.
A pre-tax (Traditional) 401(k) will not have the initial contributions taxed. In retirement, each withdrawal is taxed as income.
A Roth 401(k) will have the initial contributions taxed. In retirement, each withdrawal will be tax-free.
Example: Laura the Lawyer is still deciding which 401(k) to contribute to. If she contributes $10,000 to the pre-tax (Traditional) 401(k) she will save her tax savings for retirement. Her retirement savings look like this:
Pre-tax (Traditional) 401(k): $12,400 ($10,000 in 401(k) contributions & $2,400 in tax savings)
Roth 401(k): $10,000.
When she retires and withdraws all of her retirement accounts, after taxes she would have:
Pre-tax (Traditional) 401(k) option: $10,000 ($10,000 in 401(k) withdrawals - $2,400 in taxes owed on withdrawals [$10,000 * 24%] + $2,400 in tax savings from her contribution)
Roth 401(k): $10,000
Both options result in Laura having the same amount of money for retirement after she pays her taxes.
In this simple example, you see how the pre-tax (Traditional) 401(k) and the Roth 401(k) differ. The accounts pay taxes at different points in your life. When deciding which account to contribute to, your decision is primarily based on how much you are taxed today versus how much you think you will be taxed in the future.
If your future tax rate in retirement is higher than today’s tax rate, then a Roth 401(k) is the better option because you pay taxes today at a lower rate. If your future tax rate in retirement is lower than today’s tax rate, then a pre-tax (Traditional) 401(k) is the better option because you will pay future taxes at a lower rate. By paying taxes at the lower tax rate you will end up with more money in retirement on an after-tax basis.
Are a pre-tax and Roth 401(k) taxed any time between when I contribute and when I withdraw?
No. Once you contribute to either type of 401(k), the account grows tax-deferred until retirement.
Meaning that a 401(k) will not owe taxes for receiving a dividend, selling a security for a gain, or receiving a mutual fund distribution. These are considered taxable events with a brokerage investment account. Instead, the amounts received from these events reinvest into your 401(k), which should help it grow faster.
That is because your earnings are tax-deferred until retirement. At retirement, a withdrawal of pre-tax (Traditional) 401(k) money will incur taxes on the withdrawal amount. Over your retirement, your taxable withdrawals will include both contributions and investment returns from the contributions. The tax rate used to calculate your tax obligation is your tax rate in the year of withdrawal. These pre-tax (Traditional) 401(k) withdrawals are considered income. If your only income is a $100,000 pre-tax (Traditional) 401(k) withdrawal, then you will owe taxes as if you earned $100,000 (24% tax bracket).
The Roth 401(k) is different. These tax-deferred investment returns will be withdrawn tax-free along with the contributions you have paid taxes on. If you only withdraw $100,000 of Roth 401(k) contributions and earnings, your taxable income is $0 for that year.
My employer offers a 401(k) match. If I contribute everything to a Roth 401(k), will my employer match also go into a Roth 401(k)?
No. When you contribute to a pre-tax (Traditional) 401(k) an employer’s match will also go into your pre-tax (Traditional) 401(k). When you make a Roth 401(k) contribution, the employer match deposits into a pre-tax (Traditional) 401(k).
Example: Laura the Lawyer’s law firm matches 50% of her contributions up to 6% of eligible pay. Since Laura makes $100,000, she needs to contribute at least 6% of her income ($6,000) to max out her employer contributions. By contributing 10%, her employer’s match would be 50% of $6,000 or $3,000. If she did not contribute $6,000, she would only get a match of 50% of her contributions. If she only contributes $5,000, then her employer would give her a match of $2,500 or 50% of $5,000.
Since she contributed over $6,000 her 401(k) total contributions including her employer match would be:
Pre-tax (Traditional) 401(k): $13,000
Roth 401(k): $13,000 [$3,000 in a pre-tax 401(k) & $10,000 in a Roth 401(k)]
Employers have different ways of matching your contributions. 401(k) plans differ based upon frequency and vesting schedules.
Employer match frequency is how often an employer contributes your match to your 401(k) accounts. It depends on the plan your employer offers you. Some plans will match you one time a year. Usually, the employer match is contributed a month or two after year-end. They will see how much you contributed for the year and then make a single matching contribution to your 401(k).
Employers might also make a matching contribution each time you contribute from your paycheck. This is the most generous option because it allows your employer match contributions to be invested much sooner than the once-a-year match.
Another way employers match can differ is with a vesting schedule. Vesting is another way of saying ownership. Some employers will immediately vest your employee match, yet others will vest over a vesting schedule. There are generally two types of vesting schedules: Cliff and Graded.
Cliff vesting schedules result in you owning 100% of the amount of the match after a certain point in time.
Example: Laura the Lawyer’s employer will vest 100% of her employee match after three years of employment. Upon completing her 3rd year of service, Laura will own the last three years of 401(k) employer match contributions. If she leaves her job one week before completing her 3rd year of service, she would leave without any of the employer match.
Graded vesting schedules give you an increasing percentage of ownership for each additional year of service.
Example: Laura the Lawyer’s employer has a “2 to 6 year graded” vesting schedule. In this example, Laura will contribute enough each year to get the full employer match of $3,000. The “2” in the title means she needs to work two years before she receives any ownership. Then each subsequent year the ownership of her employer match increases by 20% until the completion of her 6th year. This table explains:
After the 6th year, she will have 100% of her employer match vest every year going forward.
Do I have to choose between a pre-tax (Traditional) 401(k) or a Roth 401(k)? Can I split my contributions between the two of them?
You do not have to choose between one or the other. You can split your contributions between both 401(k) accounts. A benefit to this is it gives you tax rate flexibility. By splitting your contributions you have some additional control over your year-end tax obligation and your tax obligations in retirement.
Example: Laura the Lawyer isn’t sure which 401(k) is best for her because she doesn’t know what her future tax rates will be. She decides to split her contributions between both a pre-tax (Traditional) 401(k) and a Roth 401(k). She wants to contribute 10% of her $100,000 income and is not concerned about the current tax burden. Some of her options are:
8% pre-tax & 2% Roth. She will put $8,000 in her pre-tax (Traditional) 401(k). She will also put $2,000 in her Roth 401(k). When she pays her income taxes, her taxable income will be $92,000 for the year.
5% pre-tax & 5% Roth. She will put $5,000 in her pre-tax (Traditional) 401(k) and $5,000 in her Roth 401(k). When she pays her income taxes, her taxable income will be $95,000.
2% pre-tax & 8% Roth. She will put $2,000 in her pre-tax (Traditional) 401(k) and $8,000 in her Roth 401(k). When she pays her income taxes, her taxable income will be $98,000.
Keep in mind that she will also receive an employer match for her contributions. The employer immediately vests 50% of 6% of eligible income. In all three examples, the employer would also contribute a $3,000 match to a pre-tax (Traditional) 401(k). If she wants equal contribution amounts in each type of account, she should include her employer match amount in her calculation. Since the employer matches are contributed into a pre-tax (Traditional) 401(k), they will never increase her taxable income.
You cannot know for certain what your future tax rates will be. A Roth 401(k) effectively locks in today’s tax rate for your money. A pre-tax (Traditional) 401(k) leaves you with the option to withdraw your money at a hopefully lower tax rate in the future. It also gives you the option in the future to convert some or all of your pre-tax (Traditional) 401(k) into a Roth 401(k)/IRA. You cannot convert a Roth 401(k) into a pre-tax (Traditional) 401(k)/IRA.
How do my tax rates change throughout my life?
When you start your law career, your salary may be more than you have ever made in your life. In law-related fields, salaries tend to increase as you gain more experience. Your starting first-year salary may be the lowest you will earn for the rest of your career.
Some lawyers may want to pursue a career in public service or at a non-profit organization later in their career. In this case, they may take a pay cut in the future to pursue a career goal. This pay cut could lower you to another tax bracket.
Taxes are also a common discussion in Washington D.C. and your state. In the past, Americans have had their tax rates raised. At other points in time, tax rates have been lowered. There is no way to know what future tax rates will be, so do not try guessing. Assume tax rates will remain where they are today and plan accordingly. But you should also be ready to adapt if they change.
Ultimately, we contribute to these accounts because we want to retire at some point. In retirement, we may not need 100% of our working years' income to support our retirement. No longer commuting to work can save money. A rule of thumb is you will need 70-90% of your working year’s income to support your living expenses in retirement. This may put you in a lower tax bracket than you are currently in.
So which account should I contribute to?
If you think you are in a low tax bracket compared to your future tax bracket, then a Roth 401(k) might make more sense because you are paying a low tax rate on your money today. Then in retirement, you will not pay any taxes on withdrawals.
When we retire, we have to live off of our retirement accounts and Social Security. Both pre-tax (Traditional) 401(k)/IRA withdrawals and Social Security are included in your taxable income during retirement. If your taxable income in retirement is significantly less than your current income, you may benefit more from a pre-tax (Traditional) 401(k).
Ideally, you will save enough to maintain the same standard of living as you have when you are working. In that case, your tax rate may stay in the same bracket. This may result in no significant benefit for you regarding either 401(k) account type.
There is no single correct answer for everyone. The determination is based on many unknowns like your future career earnings, how future tax rates change, how long you live in retirement, how much income you need in retirement, and many others. All of these factors will change over your lifetime. A Roth 401(k) may be more ideal today but in a decade the pre-tax (Traditional) 401(k) may be better.
This post cannot tell you the correct choice based on your unique life. It is written to give you the information and the considerations you need to make a more informed decision.
The future is uncertain so you will not know if you made the right decision until much later in life.
The best advice is to contact a financial planner or tax professional to help you decide which one is currently best for you. Developing Financial offers 401(k) planning as part of the Employer Benefits solution in our Developing Financial Process. Schedule a free Meet & Confer meeting right now to receive guidance on which 401(k) option is right for you!
Disclaimer: Nothing in this blog should be considered financial advice or recommendations. Your questions are unique to you and your own personal financial circumstances. You should consult with a financial professional before making a financial decision. See full blog disclaimer.