Roth vs. Pre-tax 401(k): Which is Better for Your Retirement?

Let’s dive into the debate: Roth IRAs or pre-tax 401(k)s, which is the better retirement savings vehicle?

How They Work

Here's a breakdown of how each account functions:

1. Roth 401(k): You contribute to your 401(k), but are still taxed. Your investments grow tax-free, and withdrawals in retirement are also tax-free.

2. Pre-tax 401(k): Your pay goes into your 401(k) before income taxes are taken out. The money grows tax-free, but you'll pay income tax when you withdraw in retirement.

Is Tax-Free in Retirement Always Better?

You might think tax-free withdrawals in retirement are always the better option. However, for many people established in their careers, this might not be the case.

Roth works best if you anticipate your retirement income to be substantially higher than your current income, or if you believe income tax rates will rise dramatically.

Let’s consider an example. Suppose you're married, filing a joint return, and your pre-tax income is $300,000. This places you in the middle of the 24% federal income tax bracket. For every $1 you contribute to your 401(k), you're deferring $0.24 in federal income taxes. If you max out your 401(k) at $23,500, you would defer $5,640 in federal income taxes.

Now, let's say in retirement you withdraw $300,000, and that's your only income. Your effective tax rate (average tax rate) on that $300,000, assuming you are Married Filing Jointly, would be closer to 17%. That's a significant potential tax savings. You'd need an income north of $600,000 to see your average tax rate reach 24%.

In reality, your retirement income is often lower than your peak earnings. Your mortgage might be paid off, your children are off your payroll, and you no longer need to save a large sum for retirement. A lower income could more than provide for your accustomed standard of living.

What about a Roth IRA in addition to your 401(k)?

First, if you've already maxed out your 401(k) and want to contribute more to tax-advantaged accounts, a backdoor Roth IRA could be an excellent option. Additionally, having tax diversification can be beneficial. This means having Roth money to prepare for changes, such as needing a large lump sum, facing widowhood, or dealing with changes in tax laws.

Your 401(k) is likely your best tax savings tool as a W-2 employee. So, if you want to minimize taxes and aren't maximizing your 401(k) contributions, it's time to reconsider your strategy.

The reality for me is, both Roth and Pre-tax are good. They each have their place, but for most pre-tax offers a better bang for your buck in most cases.

The information in this blog is the opinion of Nathan Tomkiewicz and does not reflect the views of any other person or entity unless specified. The information provided is believed to be  reliable and obtained from reliable sources, but no liability is accepted for inaccuracies. The information provided is for informational purposes and should not be construed as advice. Advisory services offered through Tomkiewicz Wealth Management, LLC, an investment adviser registered with the State of New York.