Saving for retirement? Pre-tax vs. Roth

If you’re saving for retirement in an employer plan like a 401(k), 403(b) or 457(b) savings plan, more and more employers are giving employees the option to make contributions using pre-tax dollars, Roth dollars, or a mixture of both.

Pre-tax contributions allow you to steer money from each paycheck into the plan before income taxes are paid on those dollars. Once in the plan, those dollars can be invested and any gains grow tax-deferred. Only when dollars are removed from the account to be spent are taxes paid. The tax rate at that time depends on your income in the year in which you make the withdrawal.

Roth contributions are also made via payroll withholdings, but they are made using after-tax funds. Similar to pre-tax contributions, Roth dollars can then be invested, and all gains grow without taxation. However, when Roth dollars are withdrawn from the plan to be spent, provided that the owner is over age 59½, no income tax is due on any untaxed dollars from gain. That’s the magic of Roth contributions.

Neither option is inherently better than the other. They’re just different and they provide different advantages.

Pre-tax contributions lower your income tax bill – and potentially your tax bracket – in the year they are made, as those contribution dollars are deducted from your gross income on your W-2. In retirement, without much other taxable income, withdrawals of this untaxed money could mean a lower tax bill than in the years the original contributions were made.

Roth contributions, on the other hand, don’t reduce the current year’s tax bill. However, if there were to be a lot of growth in these dollars – say, if they were to be aggressively invested in stocks over a long period of time – all of the growth is able to be withdrawn completely tax-free. This tax-free income could be enormously helpful in a variety of ways: keeping taxable income low can avoid Medicare premium surcharges (which are income driven); there are no annual taxable required minimum distributions (RMDs) from Roth funds; and the ability to pass tax-free assets to heirs.

The decision to make pre-tax or Roth contributions should be made based on individual circumstances, ideally with the help of a financial planner who is skilled in tax planning and projections.