When you have a Guideline 401(k) plan, you’ll have the ability to make both pre-tax (also known as traditional) and Roth contributions. Here are the differences between the two, and tips for determining which contributions are right for you.
What are pre-tax 401(k) contributions?
As the name implies, pre-tax 401(k) contributions allow you to contribute to your plan with pre-tax dollars. This means the amount you contribute will be deducted from your taxable income for the year, giving you a tax break now on earnings you’re saving for your retirement down the road. These amounts, including any earnings, will be taxed when you take them out of the retirement account.
What are Roth 401(k) contributions?
Unlike pre-tax 401(k) contributions, you’ll pay taxes on Roth 401(k) contributions in the year they are made. While this may seem like a significant downside, the benefit comes when you take a distribution. The amount you contributed as Roth will never be taxed again, if you make a qualified withdrawal of your Roth 401(k) funds, and the earnings will be completely tax-free.
Pre-tax vs. Roth contributions
Here’s a snapshot of several variations to consider:
| Pre-tax | Roth |
Contributions | Made with pre-tax dollars; reduces your current taxable income | Made after tax; taxes are paid upfront and your current taxable income is not affected |
Distributions | Subject to federal and state income taxes, according to your tax bracket at that time of withdrawal | Earnings are not taxed for qualified distributions |
Employer match | Yes | Yes, but employer match will be directed as pre-tax contributions |
Required minimum distribution (RMD) | Yes, when you reach age 72 (73 if you reach age 72 after Dec. 31, 2022) | Starting in 2024, Roth assets will not be included when calculating your RMD amount |
Factors to consider when choosing between pre-tax and Roth contributions
When deciding whether to contribute to a pre-tax or Roth account, you need to consider your overall goals, income, and tax bracket now and in the future.
Taxable income and tax bracket
Because pre-tax 401(k) contributions provide a tax break on contributions today, it can be beneficial to use that break now if your tax burden is high.
For instance, if you’re in a high tax bracket now, and you believe you’ll earn less once you reach retirement, then you may wish to consider contributing to a pre-tax account.
Roth 401(k) contributions on the other hand do not affect your current taxable income. However, provided the distribution is qualified, they also will not be taxable when distributed so will not increase your taxable income at that time.
Time until distribution and taxation on earnings
The earnings on pre-tax 401(k) contributions are always subject to taxation. On the other hand, provided the distribution is qualified, the earnings on Roth 401(k) contributions will be distributed tax-free.
Because earnings on 401(k) contributions typically grow over time, the time left before the amounts will be distributed is an important factor to consider.
Estate planning
One additional factor to consider is if the amounts may pass down to your beneficiaries. Because distributions to beneficiaries are almost always qualified, amounts distributed from a Roth 401(k) account will be tax-free to your beneficiaries.
Can I contribute to both pre-tax and Roth?
Luckily, you don’t have to choose between making pre-tax and Roth contributions. Instead, you can contribute a mix of both based on your unique goals and comfort level.
Keep in mind, the IRS sets an annual deferral limit, which dictates the maximum amount you can contribute among all your 401(k) accounts.
If you’re unsure of how to distribute your retirement savings, then consider speaking with a tax advisor who can review your specific circumstance.
This information is general in nature and is for informational purposes only. It should not be used as a substitute for specific tax, legal and/or financial advice that considers all relevant facts and circumstances. You are advised to consult a qualified financial adviser or tax professional before relying on the information provided herein.