More and more companies are offering their employees a choice of either pre-tax or post-tax (Roth) contributions within their 401(k) plans. According to a recent survey by Callan, the percent of retirement plans that offer a Roth option grew from 49% in 2010 to 71% in 2017.
But as with many aspects of investing, more choices can lead to confusion. If you’re faced with the choice between making a pre-tax or Roth 401(k) contribution, how do you know which one is right for you?
The question is especially timely now, when most of us are in the process of filing our taxes and many may be considering how to reduce their tax payments next year. And the recently passed Tax Cuts and Jobs Act makes the decision even more complicated, as tax rates will be changing from year to year as the new law is fully implemented.
Consider these three questions to help you decide:
1. Taxes – pay them now or pay them later?
Both Roth and pre-tax contributions offer the benefit of tax-sheltered growth while you’re working. When you contribute with pre-tax dollars, qualified withdrawals in retirement are taxed as ordinary income. By contrast, Roth contributions invest post-tax dollars, meaning qualified withdrawals come out tax free.
There are calculators that can help you determine the tradeoffs—check to see if your employer offers one on your plan’s website. But one of the most important variables is your estimated tax rate during retirement. If you think your tax rate will be lower in retirement than during your working years, it may make sense to go with a pre-tax contribution.
Alternatively, you might choose the Roth option if you expect your savings to generate a higher income in retirement than you currently take home. And remember, the total amount you withdraw in retirement will likely be greater than any amount you contributed, given the power of compounding returns.
2. Will your choice impact how much you save?
The choice between a Roth or pre-tax contribution will make a difference in your take home pay. All else being equal, when you make a Roth contribution, your take home pay will be lower than the same contribution made with pre-tax dollars. If a larger paycheck today will encourage you to save more than you would otherwise, you may be better off sticking with a pre-tax contribution.
A recent study from the Harvard Business School, however, shows that most people contribute the same amount to a 401(k) regardless of which contribution type they make. This is likely because most of us invest based on a fixed percentage of our pay (such as 10%), rather than by trying to optimize both our take home pay and our retirement savings.
3. How important is future tax flexibility?
Perhaps the best choice you can make is to not pick one over the other, especially since future tax rates are hard to predict. If your employer offers both options, you can always divide your contributions between Roth and pre-tax. That can give you some tax benefit today while enabling you to diversify your potential sources of income—including how much is subject to tax—when you’re retired. Many financial planners refer to this as “tax diversification” and, like investment diversification, can pay dividends today and down the road.
Please note that regardless of which path you choose, any eligible employer match may be contributed pre-tax. Make sure to reach out your employer or recordkeeper for specific plan details.
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