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is it better to do pre-tax or roth 401k?

Last Updated:  November 6, 2020

Your 401(k) at work is one of the best ways—if not THE SINGLE best way—to save for retirement! The 401(k) makes it easy, quick, relatively painless, and forces you to “dollar cost average” into your investments over time. Your 401(k) may also provide employer matching contributions and lower costs than you’d be able to get on your own due to economies of scale!

But, for all of their glory, the 401(k) can be difficult to navigate. There are rules and potential penalties. There are limits and restrictions on investments. Most importantly, most 401(k) plans today have the Roth or pre-tax option, making things even MORE confusing!

This short video explains the differences between the Roth 401(k) and the pre-tax 401(k) and will guide you towards which one is best for you and your retirement planning needs.


Hi there. My name is Greg Phelps and I’m the president of Redrock Wealth Management here in Las Vegas. I’m also your host to the RetireWire Blog and Podcast and webinars series, and a lot of other fun stuff that I put up at RetireWire specifically for retirement education.

Today’s webinar video is going to tackle a question that I got from a 401(k) client. In the age of COVID since we can’t see each other face-to-face quite as much and have the big group gatherings, we decided that doing a video and putting that out there on RetireWire would be very helpful as an education piece for the participants.

So what I’m going to do here is actually tackle a few different questions that they asked over the next several weeks, as I post these videos and create the slides and get them up on the website. But the very first question that I was asked by this 401(k) client was very specifically, “Is it better for the participants to put their money into pre-tax 401(k) contributions or after-tax Roth 401(k) contributions?

So we’re going to take a deep dive into that and talk about some of the ways that you can think about your 401(k) contributions. So let’s go ahead and get started.

Your 401(k) Is The Best Way To Save For Retirement!

The very first thing that you need to know is, the 401(k) that you have at work is absolutely one of the best ways that you can possibly save for retirement. That being said, it can also be a little bit confusing.

There are a lot of moving parts. There are investments. There’s possibly employer matches. There are rules on contributions. There are model portfolios. And there’s our topic of the day, which is, should you put your money into pre-tax or after-tax Roth 401(k) contributions?

So, we’re going to dig deep into that right now.

The Difference In Roth 401(k) and Pre-Tax 401(k) Contributions

The Roth contributions, it’s very important that you understand they’re made with after-tax dollars. So whether it’s a Roth IRA that you fund on your own out of your own savings or checking account, or it’s a Roth 401(k), it’s made with after-tax dollars. This means that you don’t get the tax break up front, but it has a whole lot of other amazing tax advantages that you’re going to get later on, which I’m going to discuss.

Now the pre-tax contributions, they’re going to be made before your tax is actually paid. So whether it’s a regular IRA, where you’re going to make a contribution and take a deduction on your tax return, so the effect is, it’s before your taxes are paid. Or, it’s your pre-tax contributions into your 401(k) plan, those contributions are going to go in before your tax is paid.

So that’s the biggest difference between Roth, which is an after-tax contribution, you’ve already paid your taxes. And pre-tax, and we also call pre-tax traditional contributions, that’s the traditional way that 401(k) contributions were made. And those are made before your taxes are paid. So that’s the real big difference. There’s a lot of other differences, but that’s the big one that you need to be focused on today.

What’s Better Roth 401(k) or Pre-Tax 401(k)?

Then the question is, well what’s better for you? Should it be pre-tax or should it be Roth?

So let’s take a look at those things. And again, just to drive home the foundation here, your contributions with the Roth are made with after-tax dollars. With the pre-tax 401(k), it is pre-tax.

Now your limits here, your contribution limits, this is currently 2020, very end of 2020. This may change. But your limits right now are $19,500, if you’re 49 years of age or younger and contributing. And if you’re age 50 or older, you get that catch-up contribution which is super-cool. The IRS allows you to put an additional $6,500 into your 401(k) retirement plan. So those are your contribution limits.

I get asked an awful lot, “Well, how much should I put into my 401(k)?” And the number one thing I tell people is, you should put in at least 10%. I know it’s very hard for a lot of people to do that, but when we talk about retirement and shaping what your future golden years are going to look like, the 10% today is going to be a lot better off than waiting. The longer you go, it takes longer to catch up, the less you’ll have in retirement and so on and so forth.

Now, the tax savings. Again, your savings are going to be, for the Roth 401(k), when you withdraw. Because with the pre-tax, your tax savings are now. If you make a pre-tax 401(k) contribution, you save the taxes you would have paid on that money, whether it’s a hundred dollars or a thousand dollars, you save that now. Whereas with the Roth 401(k), you’re going to get those tax savings when you take the withdrawal out, because if you play by all the rules, you should never ever pay taxes on Roth IRA distributions.

The other thing to think about here is growth. And the growth in that account, once you get the money in there, whether it’s pre-tax or whether it’s Roth, that growth is going to be tax-deferred. And eventually, when you pull the money out of a pre-tax account, that’s going to be taxable at your ordinary income rates.

And real quickly. When I talk about ordinary income rates, I’m talking about when you’re 62, and you decide to retire and you’re no longer working anymore, and you pull money out of your pretax account, your pre-tax 401(k), or you roll it into an IRA, which is, those are your two big options.

You pull that money out, you’re going to pay taxes on it, just like you earned it, like you’re working today and saving. So it’s taxed at ordinary income rates.

However, with the Roth IRA, it’s going to be tax-free forever, assuming you play by the rules. And the rules aren’t that complex, but I’ll get into that a little bit. So again, the distribution’s completely tax-free.

The other thing I want to mention, a real quick side note, is that if you retire before age 59 and a half, if you retire and decide to pull money out of the pre-tax or the Roth account before you’re 59 and a half, you may have some tax penalties. And that penalty is 10%. You’ll also have ordinary income taxes possibly if it’s a pre-tax account.

Real quick side note, if you leave your money in the 401(k), let’s say you’re 55. When you retire, you separate service, you leave the money in the 401(k).

Here’s a little pro-tip here. If you pull money out of the pre-tax account, you do not have to pay that 10% penalty. So that’s one benefit to leaving your 401(k) alone when you retire if you’re before age 59 and a half. After age 59 and a half, it typically makes more sense just to roll it into an IRA because your investment selections and the way that you can manage that account, it opens up a lot of doors.

So just keep those things in mind that, again, Roth after-tax contribution, tax-free withdrawals. Pre-tax, you get the tax break now, and you pay taxes just like you earned it when you’re retired.

How Roth 401(k) And Pre-Tax 401(k) Contributions Work

Let’s look at a real quick example. Let’s say we’re doing a pre-tax contribution, a traditional 401(k) pre-tax contribution, and you make $2,000 every couple of weeks, $4,000 a month. Let’s just say that your tax rate is 15%. And we can run a thousand different scenarios, but let’s just assume that your tax rate is 15%.

Now, if you’re saving 10%, you’re going to get that straight $200, because you’re not paying tax on that $2,000 semi-monthly check on the contribution of that. So let’s just say $4,000 a month, you’re not paying that that 15% in taxes and then making the contribution. You’re actually getting that full $200 per paycheck, $400 per month, into the pre-tax 401(k).

Now, let’s take a look at the Roth contribution. With a Roth contribution, that same semi-monthly paycheck is actually going to be the same $4,000. However, now you’re paying 15% in taxes on that $4,000 that you just earned.

You’re paying your income taxes now. And so, that 15%, that’s going to basically knock down that 10% that you can save, which leaves you $170 per paycheck that you can actually put into the 401(k). So it’s less money that goes in because you already paid your taxes.

So just keep that in mind. If you’re playing apples to apples with the comparison, you’re going to be saving less money into the Roth IRA because, all things being equal, you paid your taxes up front. So just keep that in mind.

How Do Roth 401(k) And Pre-Tax 401(k) Contributions Affect Your Future Taxes?

How do these tax implications affect you? Let’s look at a working life here.

What I did is I took just a sample scenario where, let’s just say, you’re 40 years old, and now you decide you’re going to start saving for retirement. That’s great. And then you retire over here, right about age 62. It’s just not on the chart there.

So you retire at age 62. And then you end up dying over here at age 84. This is a very common scenario that a lot of people have experienced throughout their life.

So, as you can see here, we’ve got a chart here with the pink, which is effectively your Roth contribution. And what you’ll notice there is, again, you have less money because you paid your taxes upfront. Less money in your account. So it may feel worse when in actuality it’s really not.

And then you can see right here, the red chart is your traditional or your pre-tax 401(k) contribution because you basically did not pay those taxes upfront. You’ve got more money than you’re using that you would have paid in taxes to grow for you. You can see here, you have more money when you retire at age 62 versus here with the Roth. That’s not necessarily a bad thing though.

Let’s go ahead and follow through with the mathematical concepts here. If your salary is $4,000 a month, all things being equal, you’re saving 10%. Your pre-tax savings is going to be $400, just like we just talked about. Your taxable income is now $3,600 because you saved that $400 into your pre-tax 401(k) at a tax rate of 20%.

You’re going to pay tax on the $3,600, you’re left with $2,880 to live off of. You paid your taxes. You saved for retirement. You did a great job, so congratulations there.

Your total savings, again, is $400 into the pre-tax 401(k) account. And we’re going to assume that you have a growth rate in this chart here of 7%. Because typically if you’re 40, 45, 50, 55, you’re going to be investing more aggressively. So just a really broad bogey on this is about 7% before retirement. Not everybody’s going to invest that aggressively, but that’s a very common approach or expectation if you’re younger, working and saving, and contributing to this 401(k).

Now let’s take a look at your Roth 401(k). Again, you still got the same salary here, the $4,000. You’re going to save the same 10%. But instead of taking it out before the taxes, now we were actually taking out the 20% in taxes of your $4,000, which leaves you $3,200. So now you’re going to invest 10% of the $3,200, because we want to get your spendable cash the same.

We’re doing apples to apples. So now you’ve got an investment into that account of $320, instead of the $400, but you still have the same spendable cash. So this is a very apples to apples comparison.

Now, when you retire at age 62, let’s just make that assumption. I try to even it out to what we see in the real world on a regular basis.

Now you’re spending that $1,150 a month. So we’ve got a nice little chunk of income coming from just your 401(k). And when I say your 401(k), we assume that you roll it over into an IRA. So your pre-tax 401(k) would go into an IRA that is all taxable. And your Roth contributions will be rolled over into a Roth IRA, which would be tax-free forever. There are other rules we’re going to discuss in a second.

Assuming that your tax rate is the same before retirement and in retirement, the math is perfectly a wash. We’re also assuming that the growth rate in retirement’s a little bit less, because you’re going to get more conservative.

So what I mean by that is, you’ll notice over here, both at age 84, both the pre-tax and the Roth end up with the same terminal value. Why? Because the tax rate is identical. If the tax rate that you’re paying now is the exact same as you’ll be paying in retirement, then there’s really no benefit to one or the other. You may feel better if you look at your pre-tax 401(k) and it’s got a higher dollar amount because you had more money invested, but you still got to pay the taxes. Mathematically, it’s a wash.

So that begs the question, “Well, are tax rates going to be the same? And are you going to pay the same blended tax rate in retirement that you are today?”

Nobody knows the answer to that question. If we did, we could build the perfect plan and that would be fantastic. But nobody knows the answer to that question.

A few things could happen. Your income could go up. It could go down. You could have legislation that changes tax rates for you. That could force your taxes higher or lower as well. So we just don’t know. We don’t know what the answer is.

Most people, if tax rates stay the exact same throughout their life, the tax brackets and the tax code, most people will pay less in taxes in retirement than they do while they’re working. Just keep that in mind.

That is most people. But if tax brackets go unfavorably higher, or we shrink the brackets, that could be the opposite as well. So I know I’m trying to answer the question, should it be pre-tax or Roth? And I know I’m not doing a very good job because there are so many variables and only you can have a sense as to what is most likely going to happen for your situation.

So let’s move on here. We can see, as I mentioned, mathematics being equal, tax rates the same, it doesn’t matter whether you’re pre-tax or Roth.

But now we’re going to talk about some different thought processes. And I alluded to this. Number one, will your income tax rate be higher or lower in retirement? If you expect tax rates to go up throughout your lifetime because tax rates right now are at historic lows. They’re very, very low relative to where they’ve been for decades. If you expect your tax rate to go up, then you really want to do the Roth because you won’t pay taxes on it later at a higher rate.

If you expect your tax rates to go down, then you really want to do the pre-tax, to save the big tax dollars now and pay less later when you pull that out. So that is the number one question that you have to ask yourself, will your tax rates be higher or lower in retirement?

Now, here’s the punchline. If you’re unsure, which most of us are, do both. If you’re unsure whether your tax rates will be higher or lower, it makes all the sense in the world to have both.

Diversify your tax base and your taxable retirement events and withdrawals and income. Diversify that like you would diversify your full investment portfolio. So keep that in mind.

Also, remember down here. All of your employer contributions. If your employer puts money in the form of a 401(k) match. In the form of a 401(k) safe harbor match. In a profit-sharing contribution. A defined benefit plan. If your employer makes any contributions for you at all, it is always going to be pre-tax when you pull that money out. Meaning that it’s going to be taxable as ordinary income when you withdraw that money.

The reason this is a very important point to consider is, if all of the money that your employer puts in for you is going to be taxable when you pull it out, you should think very strongly about putting more into the Roth now to get that balance.

The best retirement clients that we’ve done retirement planning for over the years that come to us, they have a very healthy mix of both pre-tax contributions to their 401(k)/IRA rollover and Roth after-tax contributions.

A 50/50 mix is absolutely ideal. But even if it’s 70/30, pre-tax, now this brings up some planning maneuvers that you can make while you’re retired that’ll help you save life-time taxes. Let’s talk about that.

Tax “Smoothing” In Retirement With Roth 401(k) & Pre-Tax 401(k)

Let’s take a look at the first few years of your retirement. So you retired at 62, and year number one, you’ve done your plan. You’ve got it all mapped out. You know what your vacation is, and your rent is, and a mortgage payment, the car payments, all that stuff. And you know that you need $66,430 to live off of in year one.

That’s fine. If you look at the tax brackets over here, that puts you into the 12% bracket, because that bracket married filing joint, it’s different if you’re single filing. But as you look at the tax bracket, you’re well within that, so you’re paying 12% on that chunk of money that you withdraw from your pre-tax accounts.

Year-two goes by and you need a little bit less. You didn’t travel as much. Maybe you traveled more the first year, you were having fun. And year-three comes around and you need a new car.

You don’t want to finance this car because there’s no real point in paying interest that’s just getting thrown away. An argument could be made with these low rates that it’s a possibility. But anyway, now you need $96,000 because you’re going to buy well, roughly about a $30,000 car.

That actually means that you need an extra $16,030 in the 22% bracket right here. You’ll see, now that you’re at $96 total income, you actually have a $16,000 deficit or $16,000 that you need to withdraw from pre-tax, pay ordinary income taxes on, and at a higher rate as well, 22%.

Now, if you can avoid paying 22% on that $16,000, that’s fantastic. So what you do is actually take that additional $16,000 from your Roth account, when you’re retired, to fill in the gap. You push your ordinary income or withdrawals up to that $80,000 married filing jointly mark. Then you take the additional amount out of the Roth IRA. Now you haven’t paid any tax at 22%.

So you can see how this tax smoothing concept works when it, when your life circumstances, when your retirement plan, when those goals change, or when you have a big expense that pushes you into a higher tax bracket, you have the option now of not going into that tax bracket by pulling money from the Roth IRA, which is going to save you a lot of money in lifetime taxes.

So that’s how the tax smoothing concept works. And that’s why this decision to at least have, let’s just say, 50% of your 401(k) into Roth, makes all the sense in the world. If you can get to 50%, that’s great. Even slightly less. But, that makes all the sense in the world.

Also keep in mind, every little tick that your tax rates go up in retirement, the more Roth IRA, the better. Right now you’re dealing with the known. Historically low tax rates. In the future, we’re dealing with the unknown. Potentially much higher tax rates. Probably going to be much higher than they are today. Thinking about five, 10, 15, 20 years down the road.

The Roth 401(k) & Roth IRA Rules Work Together

Okay. Moving on. There’s one thing you need to be very well aware of as a Roth 401(k) investor, and that’s the Roth IRA five-year rule. And what this basically says is that, when you put money into a Roth IRA, you can always pull out the amount that you put in completely tax-free and penalty-free, because that was your money, it was after-tax.

Now, let’s say you put $1,000 into a Roth IRA and it grows to $1,500 over the next few years. If you pull that $1,500 out, the $1,000, your contribution, is going to be tax-free. The $500 may or may not be taxable. And here’s the rule. You must be at least age 59 and a half and have the account open for five years for that $500 to not have any tax consequences or implications at all.

The tricky part about the Roth 401(k) is, the Roth 401(k) is a designated Roth account per IRS rules. So it doesn’t follow, it doesn’t play by the same rules that your Roth IRA does.

The tricky thing about the Roth 401(k), if you have no other Roth IRAs, you retire and you roll over that Roth 401(k) into a new Roth IRA that you set up, you have a new five-year rule. That five-year clock now starts. So while you can pull out your contributions and so forth, there is possibly taxes and penalties on the growth, depending on your circumstances, your situation.

There’s a very, very simple tool or trick right here that you can do to avoid that. I highly recommend this for anybody who’s going to put money into a Roth 401(k). You go to your bank, you go to vanguard.com, you go to Fidelity, wherever you want to go.

You open up a Roth IRA. You put at least some seed money into that Roth IRA to get it open, to get it funded, to get it started. Now that the five-year clock starts on the Roth IRA and assuming that that five-year window has been met, minimum seasoning on that Roth IRA, for fully tax-free distributions and you’re over age 59 and a half. Now you’re 62, you roll your Roth 401(k) into the Roth IRA, your five-year window is met. You can pull money out at will, and you have no issues.

Now, I don’t want to harp on this too much because most people will never have that issue, because your capital contributions to the Roth, 401(k), the Roth IRA, they’re going to be tax-free, penalty-free. So I don’t want to mislead you and say that this is going to affect everybody.

However, it’s just smart. Get the seasoning done. Don’t even have to worry about it.

If you actually were to pull out more than your contribution, let’s say you had a lot of really good growth in your Roth 401(k) or your Roth IRA, and you actually pulled out more than your contribution, you don’t have to worry about the penalties, assuming you’re playing by the rules or any taxes on that growth. So that’s just a little tip. If you’re going to do Roth 401(k), get a Roth IRA open. Put something in it. You can go to Vanguard and do a life strategy fund or do a target-date retirement fund. Those are fantastic. And that way the Roth seasoning window starts.

What’s Better? Roth 401(k) or Pre-Tax 401(k)?

Real quick in summary. I’d like you to think about the savings in taxes that you’re getting now. What is your income tax rate now? What are you paying? If your blended tax rate is 10 or 15%, and you’re not really getting that much of tax savings to benefit, lean more towards the Roth. You’re not saving that much in taxes anyway.

If you’re making a lot of money and you’re paying 25, 30, blended rates. 25, 30, or higher in taxes, which most people are not, thankfully, then you really need to lean more towards the pre-tax. You want the tax savings now, and you’re just going to have to hope that it works out later.

So again, if you’re in a lower tax bracket now—if you expect to make more money later—then you want to lean towards the Roth, and pre-tax later.

What I mean by that also is, if you are that 40-year-old or 45-year-old, you haven’t hit your peak earning years. And you know that when you’re 55 or 60, you will be in your peak earning years, you’re going to be making more money and paying more in taxes. Do the Roth 401(k) now, and maybe switch that over later when it’s more advantageous, when you’re at a higher income tax level.

And again, the fallback is, when in doubt, always lean towards 50/50 Roth and pre-tax. You’re going to get the benefit of both. You’re going to get the best of both worlds.

It’s not going to necessarily change your life right now while you’re saving, but as we saw on the tax smoothing page, looking down the road here, if you can save 22% on some of your distributions because you were smart and planned ahead and had some tax-free money to withdraw, that 22%, that’s an extra 10% in tax that you were paying over the 12. That’s a lot of money.

On that $16,000, it’s $1,600 bucks on this one year (the 10% from 12% to 22% brackets). Multiply that out by 10 different opportunities or times to use a strategy. Or, 15 over your 20 or 30-year retirement, and we’re talking tens of thousands of dollars, possibly into six figures or more, by using this strategy.

And having the ability to determine when you’re retired, where you’re going to pull your income from. Pre-tax and pay the taxes up to the tax bracket limits, and not go into a higher bracket. Or, after-tax Roth, tax-free forever, to make sure you’re not paying tax at these really high rates while you’re retired.

Summary Roth 401(k) or Pre-Tax 401(k)

That’s all I have for you today on what is better for you? Pre-tax contributions to your 401(k) or after-tax Roth contributions?

It’s not an easy decision. When in doubt, always go 50/50. And also remember, your employer contributions will always be taxable when you withdraw them. That should change the way you think as well, because those taxable distributions if everything is going to be taxable, that could easily put you into that 22% bracket when you are pulling money out later. So put more into the Roth now.

Just keep that in mind. 50/50 is a great place to start. If you can afford it, do the full Roth contribution and put more money in. Instead of that $320 that we talked about if you can put more money in, do it. Put more money in and do it in the Roth. Because, even though you’re not saving the taxes now, you get those big benefits later.

There are also some other big benefits after you pass with how the Roth and the IRA are distributed to your beneficiaries and heirs. And again, having both types is good in that direction as well, thinking longer-term.

So, that’s all I have for you today. Once again, my name is Greg Phelps with Redrock Wealth Management here in Las Vegas. The blog and podcast host and webinar host to retirewire.com. Thank you so much for your time. I hope you found this helpful. And if you have any questions, feel free to reach out through retirewire.com or redrockwealth.com.

Is It Better To Do Pre-Tax Or Roth 401(k) FAQs?

How does the Roth 401(k) work?

You put money into a retirement savings account directly from your paycheck but after taxes are withheld. When dones correctly, you will avoid all future taxes on this account forever!

How does the Pre-tax 401(k) work?

You put money into a retirement savings account directly from your paycheck and before taxes are withheld. Income taxes will be owed on all distributions from this part of your 401(k) or rollover IRA when withdrawn. Penalties may also be due when money is withdrawn before age 59 and 1/2.

What’s better? Roth 401(k) or Pre-tax 401(k)?

Generally speaking, if your tax rate will increase in retirement you’re better off with the Roth 401(k) contributions. If your taxes will decrease in retirement you’re better off using the Pre-tax 401(k) contribution. When you’re unsure of your future tax rates, you should at least consider contributing 50% to Pre-tax 401(k) and 50% to Roth 401(k).

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