Should I fund a Roth or pre-tax account? This question is tricky because it can take decades before you realize whether or not your decision was wise. Financial advisors say that a few crucial elements might make a choice simpler, as well as circumstances where “success” is more likely.
According to Ellen Lander, principal, and creator of Renaissance Benefit Advisors Group with headquarters in Pearl River, New York, “there is no clear answer; therefore, you have to leap.”
Main Distinctions Between a Pre-tax Account from a Roth Account
Americans who fund qualifying retirement accounts like 401(k) plans or individual retirement accounts receive financial benefits under the tax rules. The main distinction between a pre-tax and a Roth account is when savers receive those benefits and when their taxes are due.
Pre-tax accounts give savers an immediate tax break. Contributions are not subject to income tax; instead, they are subtracted from savers’ taxable income, lowering their tax obligation. So they’ll have to pay taxes after they take money out of retirement accounts.
With a Roth account, on the other hand, investors pay tax up front when they contribute but not when they withdraw money in retirement.
The Best Option is a “Tax Bet”
Taxes are the main factor to consider when deciding whether to save in a pre-tax or Roth account. It all boils down to this: Will you pay more or fewer taxes when you retire?
If higher, saving in a Roth account now and paying taxes at your existing, lower rate makes sense. If lower, it often makes more financial sense to save in pre-tax accounts and postpone paying taxes.
The decision between pre-tax and Roth investments is irrelevant mathematically if your current and future tax rates are the same, according to David Blanchett, who’s head of retirement research at PGIM, an asset-management division of Prudential Financial. In that case, you’ll have the same amount saved for retirement after taxes.
However, due to unpredictable personal circumstances and potential policy changes, it is hard to predict whether your future tax rate will be lower, the same, or greater.
Ted Jenkin, a licensed financial advisor and the CEO of oXYGen Financial, described the decision as “essentially just a tax bet.”
A Roth is Ideal for Young Professionals in Most Cases
Financial gurus say that young people in their early twenties and thirties are usually the best candidates for Roth savings.
These young professionals have a good chance of earning higher salaries later in life and enjoying higher living standards when they retire. These higher salary and income requirements could result in a higher tax rate in the future.
“I’d say a Roth account always wins when it comes to younger people,” said Lander. Jenkin, a CNBC’s Advisor Council participant, advises customers of all ages “nearly always” to use a Roth 401(k) or IRA when their federal tax rate is at or below 24%.
This includes married couples and single people in 2022 with taxable incomes under $340,100 and $170,050, respectively.
When a Pre-tax Account is Ideal
Spending usually decreases after retirement compared to one’s peak working-years expenditures. A pre-tax 401(k) or IRA may be financially advantageous since a reduced tax rate may be associated with these lower-income needs.
According to the 2021 Consumer Expenditure Survey, households’ average annual expenditure peaks between the ages of 45 and 54, or about $84,000, while spending decreases to approximately $52,000 annually for people 65 years of age and older.
Naturally, there is no assurance that your tax rate will decrease as you age. Furthermore, some people might believe they can only afford to put money down for retirement if they receive the tax advantage upfront from a pre-tax account.
According to advisers, a pre-tax retirement plan and using the additional cash the tax savings leave in your paycheck to help pay down debt may be a better option for someone with high-interest credit card debt or another sort of loan.
The Benefits of Diversification
Besides advising retirement savers to diversify their holdings, financial counselors frequently extol the virtues of tax diversification, particularly for investors for whom the distinction between a pre-tax and Roth account is ambiguous.
To balance their tax risk, these investors might decide to allocate half of their contributions to a Roth and the other half to a pre-tax account.
“I really like the [option] of half and half,” Lander said. “You’re just partly mistaken.”
Retirees have financial options thanks to the two tax tiers. For instance, retirees about to enter a higher tax bracket may choose to remove funds from a Roth account to meet their income requirements. The individual wouldn’t move into a higher tax rate because a Roth withdrawal doesn’t contribute against taxable income.
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Bio:
For over 20 years, Jeff Boettcher has helped his clients grow and protect their retirement savings. “each time I work with my clients, I’m building their future, and there are few things that are more important to a family than a stable financial foundation.”
Jeff is known for his ability to make the complex simple while helping navigate his clients through the challenges of making the right investment decisions. When asked what he is most passionate about professionally, his answer was true to character, “Helping my clients – I love being able to solve their problems. People are rightfully concerned about their retirement income, when they can retire, how to maximize their financial safety and future income.” Jeff started Bedrock Investment Advisors for clients who value a close working relationship with their advisors.
A Michigan native, Jeff grew up playing sports throughout high school and into college. While Jeff is still an ‘aging’ athlete, Jeff will take more swings on the golf course than miles running these days. He creates family time, often with weekly excursions to play golf, a hobby he shares with his three young children.
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