April is Financial Literacy Month, so I’m writing about some general financial literacy topics. Today’s topic: Pre-Tax and Roth retirement savings and how to decide which to use.

Saving can be hard. Not just because you have to come up with money to save, but because once you do, you have a bewildering range of choices. So many that a lot of people throw up their hands in despair and leave the money in their bank account where it will effectively rot over time, losing purchasing power to inflation. For today’s purposes, I’ll assume you’ve already read about the savings hierarchy and you’ve got your emergency savings, so we’ll talk about retirement savings accounts.

Retirement savings accounts– employer accounts like 401(k)s and 403(b)s, and Individual Retirement Accounts, or IRAs– can come in two tax “flavors”: pre-tax and Roth, or after tax. Which one is best? It depends on a lot of factors.

First of all, what does pre-tax or Roth mean? In a pre-tax retirement savings account, you don’t pay income taxes on the money you deposit into the account. That money grows tax-free until you retire and start withdrawing the money in the account to spend it, at which time you’ll pay taxes on it. Roth accounts work the opposite way: you pay income taxes on the money you deposit into the account, and then it grows tax-free until you retire, and the withdrawals in retirement are also tax-free. With pre-tax savings, you are deferring taxes until retirement. With Roth savings, you’re prepaying taxes during your working years.

Which is better depends on a lot of things. The first consideration is, what is your current tax bracket, and what do you think your tax bracket in retirement will be? For highly-compensated individuals in high tax brackets, saving current taxes can be very beneficial. If your income puts you in the 35% federal tax bracket, then maxing out your 401k with pre-tax dollars– $20,500 this year if you’re under 50– will save you $7,175 in federal taxes, and more in state taxes. If you think that you’ll be in the 24% tax bracket in retirement, your withdrawals will be taxed 11% less than the money would have been during your working years. On the other hand, a person in the 12% tax bracket gets much less of a tax benefit for pre-tax contributions. That $20,500 would only save $2,460 in federal taxes. If that person is young and anticipates their salary will grow and their future tax rates will be higher, a Roth contribution might make more sense.

The quick summary: the higher your current tax rate, the greater your tax benefit from pre-tax savings; the lower your current tax rate, the greater your tax benefit from Roth savings.

Taxes aren’t the only factor; other considerations can come into play. Those include:

  • How long does your account have to grow and compound? The longer the timeline until you withdraw, the more you benefit from tax-free growth in a Roth account. For example, a 25-year-old who contributed the maximum to a Roth IRA this year– $6,000– and earned a 7% annual return until they turned 65 would have about $90,000 tax-free dollars– all at a cost of $720 ($6,000 x 12% tax rate).
  • Would a pre-tax contribution reduce your AGI enough to be eligible for the American Opportunity Tax Credit? If so, then add $2,500 per student to the savings from a pre-tax contribution.
  • Is this an income year for the FAFSA? If so, Roth contributions increase your tax liability, which is subtracted from your income in the FAFSA formula and could therefore result in larger financial aid awards.
  • What does your total retirement savings picture look like? People who have aggressively saved in pre-tax accounts are sometimes surprised to find themselves in a higher tax bracket in retirement, subject to income-related Medicare premium surcharges, or without spending flexibility for occasional one-off large expenses. In such a situation, adding some Roth assets to the savings mix can be beneficial.
  • At what age do you intend to retire? Pre-tax retirement savings accounts can’t be tapped until age 59-1/2 without incurring penalties. Roth accounts allow for withdrawals of contributions, penalty-free, subject to some conditions. People intending to retire at younger ages need to have assets that can be tapped into at that age.

Of course, your situation may have nuances beyond what I’ve outlined here, so it’s always a good idea to check with your tax or financial advisor for specific guidance.

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