Should I Make Pre-Tax or Roth Contributions

This has been a popular topic that’s been heavily debated since the introduction of Roth capabilities. There’s no “one size fits all” answer to this question, and no real right answer. However, there are some important factors for you to consider when determining the optimal strategy for your situation.

Quick Definitions and Concepts

• Progressive tax – Tax rates (percentages) increase as income increases. The amount of income you have in each bucket (or bracket) is taxed at that specified rate. As you fill up each lower bracket, each dollar above that is taxed at the next higher rate.
• Marginal tax – This is the top tax bracket you are in. It’s also referred to as the amount of tax you’ll pay for each additional dollar earned.
• Effective tax rate – This is your average tax rate. Defined by your total tax liability divided by your total taxable income. Due to our progressive tax schedule, this is always lower than your marginal tax rate.
• Tax-deferred accounts – Retirement plans that have pre-tax or Roth contribution options are tax-deferred accounts. That means that no taxes are due on any gains, interest, or dividends received in that account until those funds are withdrawn. 

What Are Pre-Tax Contributions

Pre-tax contributions are contributions that are removed from your taxable income in the year they are made. While this amount is removed from current income, it is really deferred, as income taxes will be due on this amount when it is eventually withdrawn. This reduces your taxable income, and effectively lowers the amount of taxes currently owed.

The reduction in taxes is dependent upon your marginal tax bracket, the highest tax bracket for your level of income. Since the US has a progressive income tax, any reduction comes directly out of the highest bracket. 

Your tax liability is not reduced dollar per dollar, but is reduced by your applicable bracket. If you defer $10,000 of income when you’re in the 24% tax bracket, you’ll save $2,400 ($10,000 x 24%) on income taxes this year. When you eventually withdraw that $10,000 (plus any gains) from your retirement account, you will be taxed at the income tax rates that are currently in place.

What Are Roth Contributions

Roth contributions are contributions that do not receive any current-year tax deductions. You pay income taxes on the money contributed during the current year. Many people mistakenly classify these as tax-free accounts, but they are actually tax-deferred, since there are specific requirements that must be met to receive the tax-free withdrawals.

Since you’ve already paid taxes on these contributions, you will not have to pay income taxes on future withdrawals from these accounts, provided you abide by the rules. This applies to any realized gains in the account. Contributions can always be withdrawn tax-free since taxes have already been paid on this money.

The basic rules for tax-free withdrawals are that the Roth account has to have been open and in-place for at least 5 years, and you have to be age 59 ½. The 5-year period starts on January 1^st of the contribution year (if you opened a Roth IRA in March 2024 and made prior year contributions (2023), then the 5-year period starts January 1^st, 2023).

Inaccurate Generalization

It is often said that if you are in a higher tax bracket now than you expect to be in during retirement (or when you withdraw funds), that you should make pre-tax contributions. Conversely, if you’re in a lower bracket now than you expect to be, then you should make Roth contributions.

However, these are very simplified and generalized statements. The realities are much more complex. Here are a few things to consider.

• While it’s true that pre-tax contributions pull money from your marginal (highest) tax bracket, your marginal tax bracket should not be used to determine the taxes due on withdrawals.
  • Since we use a progressive tax schedule, your withdrawals will be taxed at various rates depending on your total income and sources of income in retirement. As a result, it would be more accurate to use your effective tax rate in retirement. Though you may want to make adjustments for other taxable income such as Social Security benefits or annuity payments.
  • If the tax brackets remain relatively unchanged (except for annual inflation adjustments), this means that it’s highly probable that the taxes paid on your withdrawals will be lower (percentage wise) than the taxes saved on your contributions.
• You are not paying taxes on your Roth contributions at your marginal tax rate. At the end of the day, your applicable tax liability for the year is your effective (or average) tax rate. As a result, this is the rate that should be used when calculating the taxes paid on Roth contributions.
  • However, the argument can also be made that since pre-tax contributions pull money directly out of the highest tax bracket, then choosing to make Roth contributions instead would be choosing to pay those additional taxes at your highest rate. This is an opportunity cost that is often considered and used since there is no definitive way to compare these two different types of contributions.
• Tax rates and brackets are not static. Tax brackets are generally adjusted annually to account for inflation. Congress has the power to change the tax rates as needed, which has been done numerous times. In the grand scheme of things, we’re currently at low tax rates, historically speaking. While it’s likely that these rates will be increased in the future to help combat our national deficit, nothing about the future is certain.

Comparisons

Due to the uncertainty of future tax rates, tax laws, and income levels, it’s impossible to make an accurate comparison between pre-tax and Roth contributions. The best we can do is use the information available, along with various assumptions, to provide a best-guess. This should be reevaluated as changes are made and new information becomes available. 

One example that is frequently used in the industry is that of finite contributions and no tax changes. For example, if you have $10,000 to invest in pre-tax dollars or $10,000 minus taxes to invest in Roth, then the outcome will be the same either way. This assumes that identical returns are received and that future tax rates are the exact same as current tax rates. However, this scenario is highly unlikely, unless you have a very short time horizon.

Making the Decision

Much of the decision depends on your current and expected future situation, as well as your preferences and risk tolerance. If you’re in one of the top brackets, it may make more sense to defer taxes since you’ll pull funds from the highest bracket and distribute them throughout the lower brackets. However, if the tax brackets increase substantially before you retire, this may end up costing you more in taxes in the long run.

If you’re in a lower tax bracket, or want more certainty about your taxes and retirement income, then Roth contributions may be a better bet. You know how much you’re paying in taxes now, and know you won’t have to pay taxes on future distributions if you follow the rules. It’s also likely that taxes will increase in the future to help manage the national deficit.

Pre-tax contributions may also help increase your current cash flow, since you’re saving on taxes. You can use this money to invest. If done properly, this can help reduce future taxes, provide additional resources in retirement, and/or be used for future large purchases or other expenses. 

Final Thoughts

The decision to make pre-tax or Roth contributions involves many variables and assumptions about the future. The most important aspect is that you are making contributions to a retirement account. Whether it’s pre-tax or Roth, you should be in a much better position financially in the future as long as you’re making continual contributions and adhering to a deliberate investment strategy. 

If you’re interested in optimizing your tax strategy and taking steps to minimize the taxes you pay over the course of your lifetime, it’s highly recommended that you meet with a financial planner and tax professional. Together, they will be able to model out various scenarios to develop strategies that are tailored to your specific situation. 

These strategies will need to be reviewed and analyzed frequently, making adjustments as needed. Tax laws and investments are complex and dynamic subjects that are constantly changing. Chances are that your life isn’t static either. It’s important to communicate any life changes as soon as possible to your financial planner and your tax professional, so they can inform you if any changes need to be made.