During one of my recent blog posts, I went through the discussion of deciding how much to contribute to your employer-sponsored retirement plan if you have one available to you. On top of this, more and more employer-sponsored retirement plans are beginning to offer employees the ability to make Roth contributions instead of pre-tax contributions. So, what are the differences between those two types of contributions and what should you do?

Pre-tax contributions are just that. You don’t pay taxes on the money you put into your 401(k). Or in other words, you get a tax deduction for the amount of money you put into your 401(k). This money doesn’t get taxed now but gets taxed later.

Roth 401(k) contributions to a operate just like a regular Roth IRA. You pay taxes on the money you put into the 401(k). Or in other words, you don’t get a tax deduction for the amount of money you put in. However, this money is completely tax free once you pull it out later if you’re above age 59 ½.

The great debate of whether you should make contributions as pre-tax or as Roth can be summed up in two words: it depends. The discussion all comes back to tax rates. Pay taxes now or pay taxes later? We say this often but if you can tell us what your income will be each year for the rest of your life and when you’re going to die, we’ll build the perfect financial plan. Impossible right? Throw on top of that tax rates that move up and down based on the U.S. government and you’ve got a lot of assumptions that have to be thrown into an equation. So, it’s best to take what we do know right now and build a simple scenario off of it.

Let’s say you make a lot of money currently… enough to be in the top tax bracket of 37%. If you contribute the maximum amount of pre-tax money to your 401(k), that equates to a $19,500 contribution and tax deduction. So, if you make a $1,000,000, your taxable income is now $980,500 because you got a deduction for that contribution (it’s pre-tax). That $19,500 would have resulted in an additional $7,215 in taxes owed to the government if you didn’t contribute. That’s pretty substantial!

The goal of contributing money pre-tax is that you’re going to be in a lower tax bracket when you begin to pull the money out when you’re retired/in need. If you’re 70 years old and find yourself in the 20% tax bracket and you pull $19,500 out of your 401(k), you’re only going to owe $3,900 in taxes. Not to mention all the growth your contribution had over the years that was tax deferred! In the simple situation, you saved $7,215 in taxes when you contributed and only ended up owing $3,900 on the same money many years later when you pulled it out. Victory!

Now let’s look at efficiently contributing to a Roth IRA… let’s say you’re just starting out in your career and find yourself in the 20% tax bracket. You’re a great saver and max out your 401(k) with a contribution of $19,500 but as a Roth contribution. You get no tax deduction for making a Roth 401(k) contribution. That $19,500 is still taxed at the normal 20%, so $3,900 in taxes.

Fast forward many years when you’re in need of retirement income and you pull $19,500 out of your Roth 401(k). Let’s say your income has gone up over your career and now you find yourself sitting in the 37% tax bracket. The money you take out of your Roth IRA is completely tax free (and all the gains earned over the years – if you are over 59.5 and have held the Roth IRA for at least 5 years)! Instead of owing $7,215 in taxes, you’re free and clear and owe $0 of taxes on that money. By paying the taxes up front and making your contributions as Roth, you’re able to take distributions in retirement with a 0% tax rate.

In both of these scenarios it works out and is efficiently done. The goal is to ultimately pay taxes at the lowest tax rate possible. However, as I’ve previously stated, it’s impossible to perfectly predict. If you’re in the top tax bracket, pre-tax contributions are likely the way to go. Find yourself in one of the bottom tax brackets and relatively young? Roth contributions are likely your choice. But, there’s many other variables at stake here. The best recommendation I can make is talk it through with someone who knows your entire financial picture and can help make the best decision for your overall financial well-being. We’re here to help!

Roth 401(k) plans are long-term retirement savings vehicles. Contributions to a Roth 401(k) are never tax deductible, but if certain conditions are met, distributions will be completely income tax free.  Unlike Roth IRAs, Roth 401(k) participants are subject to required minimum distributions at age 72 (70 ½ if you reach 70 ½ before January 1, 2020).

Like Traditional IRAs, contribution limits apply to Roth IRAs. In addition, with a Roth IRA, your allowable contribution may be reduced or eliminated if your annual income exceeds certain limits. Contributions to a Roth IRA are never tax deductible, but if certain conditions are met, distributions will be completely income tax free.

401(k) plans are long-term retirement savings vehicles. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty.

Scenarios used are hypothetical examples for illustration purposes only.

Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person's situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.

Any opinions are those of Carson Odom and not necessarily those of Raymond James.

This material is being provided for information purposes only and is not a complete description, nor is it a recommendation.

 

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