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When it comes to your 401(k), one of the important decisions you need to make is whether to make pretax or Roth contributions. However, experts say that this choice can be complicated.
Pretax 401(k) contributions can lower your adjusted gross income, but you will owe taxes on the growth when you withdraw the money. On the other hand, Roth 401(k) contributions do not provide an upfront tax break, but the money can grow tax-free.
According to a recent Vanguard report based on approximately 1,700 retirement plans, 80% of employer retirement plans offered Roth contributions in 2022, compared to 71% in 2018.
While considering your current and future tax brackets is important, experts advise that there are other factors to take into account.
“It’s challenging to speak broadly about this decision because there are many factors to consider,” said Ashton Lawrence, a certified financial planner at Mariner Wealth Advisors in Greenville, South Carolina.
Here’s how you can determine which option is right for your 401(k) plan.
Current vs. future tax brackets
One of the key factors to consider is whether you anticipate being in a higher or lower tax bracket during retirement.
In general, pretax contributions are more beneficial for higher earners due to the upfront tax break. However, if you expect to be in a lower tax bracket, it may make sense to pay taxes now with Roth contributions.
“If you’re in the 22% or 24% bracket or lower, I think the Roth contribution makes sense, assuming you’ll be in a higher bracket upon retirement.”
– Lawrence Pon, CPA at Pon & Associates
Roth 401(k) contributions are typically more advantageous for younger workers who expect to earn more later in their careers, according to Lawrence Pon, a certified financial planner and certified public accountant at Pon & Associates in Redwood City, California.
“If you’re in the 22% or 24% bracket or lower, I think the Roth contribution makes sense, assuming you’ll be in a higher bracket upon retirement,” he said.
Although it’s uncertain how Congress may change tax policy, various provisions from the Tax Cuts and Jobs Act of 2017 are set to expire in 2026. These include lower tax brackets and a higher standard deduction.
Experts suggest that these anticipated changes may also impact the analysis of pretax versus Roth contributions.
“We’re currently in this low-tax sweet spot,” said Catherine Valega, a certified financial planner and founder of Green Bee Advisory in Boston. She refers to this period as the time before tax brackets potentially increase. “I say taxes are on sale.”
“We’re currently in this low-tax sweet spot.”
– Catherine Valega, Founder of Green Bee Advisory
While Roth contributions are a “no-brainer” for young, lower-income individuals, Valega stated that the current tax environment has made these contributions more appealing for higher-income clients as well.
“I have clients who can contribute $22,500 for three years,” Valega said. “That’s a significant amount of money that will grow tax-free.”
Furthermore, recent changes from Secure 2.0 have made Roth 401(k) contributions more attractive for certain investors. Plans now have the option to offer Roth employer matches, and Roth 401(k)s no longer have required minimum distributions. Of course, the availability of these features may vary depending on the employer.
Consider your ‘legacy goals’
“Legacy goals” should also be taken into consideration when deciding between pretax and Roth contributions, according to Lawrence from Mariner Wealth Advisors.
“Estate planning is becoming increasingly important for individuals,” he said.
Since the passage of the Secure Act in 2019, tax planning has become more complex for inherited individual retirement accounts (IRAs). Previously, non-spouse beneficiaries could stretch out their withdrawals over their lifetime. However, now they must deplete the inherited IRAs within 10 years, as mandated by the “10-year rule.”
The withdrawal timeline is now much shorter and can impact the beneficiary, especially if they are in their highest earning years,” explained Lawrence.
However, Roth IRAs can be a better estate planning tool than traditional pretax accounts because non-spouse beneficiaries are not required to pay taxes on withdrawals.
“Everyone has their own preferences,” Lawrence added. “We simply aim to provide the best options based on their goals.”
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