You may have heard the terms “Pre-tax” (or Traditional) and “Roth” thrown around as you’ve ventured into the 401(k) retirement savings world. Don’t worry, they’re both types of 401(k) contributions that you can make in your Guideline plan.
So what’s the difference? Primarily, the difference is when you are taxed.
Pre-tax 401(k) contributions
Pre-tax or Traditional 401(k) contributions allow for pre-tax contributions and taxable withdrawals. When you make Pre-tax 401(k) contributions, your contributions are taken directly out of your paycheck before federal or state taxes are applied, basically reducing your taxable income for the year. Because these automatic contributions allow you to delay paying taxes now, they're often referred to as deferrals, or deferral contributions. Later, during retirement, you'll be taxed on any withdrawals from your account, which include the money you originally invested, plus any earnings that have accumulated over time.
Roth 401(k) contributions
Roth 401(k) contributions allow for post-tax contributions and tax-free withdrawals. When you make Roth 401(k) contributions, your contributions are still included in your yearly taxable income, meaning you pay taxes on them in the year you make them. You might not like seeing the tax dent in your paycheck right now, but later on, during retirement, withdrawals from your Roth 401(k) will be completely tax-free. With Roth contributions, you won’t pay taxes on the earnings that you’ve accumulated.
Pre-tax, Roth, or Both?
In general, it’s good strategy to try to pay the least amount of taxes possible over the course of your lifetime. It may sound counterintuitive, but you’ll want to pay your taxes in the years that you make less money, though you may feel less able to, and defer your taxes in the years that you make more money.
Chances are, in the years that you make less money, you’ll be in a lower tax bracket, meaning the overall amount of taxes you’ll pay will be lower. In the years that you make more money, you’ll be in a higher tax bracket and will be paying more taxes. We think it’s better to take a small hit and pay taxes on your Roth contributions when you are receiving less income, than to pay a huge chunk of your income to taxes when you’re making the big bucks. This usually means that when you're young and just starting out in your career, you’ll contribute more towards a Roth 401(k). As you gain experience and your salary grows, you may want to contribute more towards a Pre-tax 401(k).
Keep in mind that it’s your taxable income (your income after accounting for deductions, exemptions, any outside income sources, etc.) that determines your tax bracket. In deciding between Pre-tax and Roth, it could really pay off to consider how your contributions might affect your tax bracket.
To start, think about using the following contribution strategies based on your current tax bracket. You can see which tax bracket you’re in here. If you’re thinking of saving an amount that is enough to lower you into the next tax bracket, consider making at least enough Pre-tax contributions to get to that bracket. Then, use that new tax bracket as your starting point for applying these guidelines to the remainder of your contributions.
|If your tax bracket is….||Then you might contribute….|
|...10% or 15%||...100% into Roth|
|...25%||...75% into Roth and 25% into Pre-tax|
|...28%||...50% into Roth and 50% into Pre-tax|
|...33%||...25% into Roth and 75% into Pre-tax|
|...35% or 39.5%||...100% into Pre-tax|
***Please keep in mind that these are general recommendations provided by Guideline and should not be taken as personalized financial advice. What is right for an individual 401(k) participant will vary based on that individual’s specific financial or life circumstances.
Lucky for you, Guideline 401(k) plans offer both Pre-tax and Roth contribution options. Employees can choose to allocate their contributions between both types in the same account. And no matter how you choose to distribute your contributions, you can always feel good knowing that you’re enjoying the lowest retirement savings fees in the industry with Guideline.