Should You Contribute to Pre-Tax or Roth?

September 14, 2022

The decision to contribute to a Traditional IRA/401(k) versus a Roth IRA/401(k) can mean the difference of thousands of dollars paid in taxes over time. So, when does it make sense to do one over the other? Or should you contribute to both? The answer is: It depends. But you can come up with a good plan after having a little understanding on the benefits of each type of account.

Contributions to a Roth account are made with after-tax dollars. This means that you do not deduct your contributions from your income at the end of the year. This also means that you will not pay taxes on Roth account distributions when you retire. Roth accounts are not subject to Required Minimum Distributions at age 72, distributions are not included in your provisional income when collecting Social Security benefits, and they are not included in the calculation for IRMAA surcharges on Medicare premiums.

The primary benefit of contributions to a Traditional IRA/401(k) however, are they are made with pre-tax dollars.  So, depending on your income, you may be able to reduce your tax liability in the year you contribute.

If your goal is to optimize your income over time, your primary concern will be balancing your tax brackets over the course of your life; or matching your current tax bracket with your tax bracket during retirement. For example, if your current income places you in the 32% tax bracket, but you only expect to have enough income during retirement to place you in the 12% tax bracket, you would maximize your income by contributing to the Traditional account now and claiming the tax deduction.

So, what if you expect to be in the same tax bracket now versus during retirement? Then it doesn’t matter so much. Let’s say that you are in a 25% tax bracket and want to contribute $10,000 of pre-tax salary to a retirement account. If you save it in a traditional retirement plan, it grows to $20,000. When you withdraw that $20,000, you will be left with $15,000 after taxes are paid. However, if you contribute to a Roth account, your $10,000 of income would be reduced to $7,500 after taxes are paid. The investment would still double to $15,000 and then can be withdrawn tax-free – the same amount as in a pre-tax account.

When I work with a client whose income falls just over the threshold of a higher tax bracket, it sometimes makes sense for them to contribute both to a Traditional and Roth account. For example, if most of your income falls within the 24% tax bracket, but $5,000 is over the line and will be taxed at the 32% level, you can contribute the $5,000 to your Traditional account for a deduction and put the rest in your Roth account. That way you avoid paying 32% on any of your income. 

Not everybody is concerned with optimizing their strategy though. For some people, it’s psychological. If you wish to max out your 401(k) contributions ($20,500 in 2022 with a $6,500 “catch-up” for people over 50), and don’t care whether the amount is before or after tax, then contributing to your Roth account will mean greater savings since you've already paid the taxes upfront.

Every person’s situation is going to be different. If you have questions about where you should be contributing your money, please reach out to one of our advisors who will be happy to help you develop a strategy.

**Please note that all assumptions are based upon current tax laws**


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