The contribution type that works best for you depends on what plans your employer offers, how much you can contribute, and tax rates. Here’s how you can compare the two options.
What’s the Difference Between a Roth IRA and a Pre-Tax Contribution Plan?
The difference between Roth IRAs and pre-tax contribution plans is not limited to the tax treatment of contributions and withdrawals. For example, a $6,000 contribution to a pre-tax retirement plan is an untaxed contribution and, therefore, it’s tax-deductible. On the other hand, to make a $6,000 Roth IRA contribution, you’d have to have $6,000 after you paid the tax. Let’s say you earn $80,000, which would put in the 24% tax bracket with an effective tax rate of 16.52%. You’d have to earn about $7,187 pre-tax to make that same $6,000 contribution.
Distributions
Since you’ve already paid tax on the money before you put it in a Roth IRA, plan distributions are tax-free. No tax is paid on your accumulated interest and gains if you meet certain criteria. Distributions that meet Roth IRA criteria are called qualified distributions. On the other hand, distributions from pre-tax contribution plans are 100% taxable. All of your contributions, interest, and gains are tax-deferred, meaning you pay taxes when you withdraw money from your plan. For example, if you are in that same 24% tax bracket at retirement, with the same 16.52% effective tax rate, you have to withdraw roughly $41,926 from a pre-tax contribution account such as a 401(k) to have $35,000 to spend. A $35,000 qualified distribution from your Roth IRA, on the other hand, would be tax-free, and you would withdraw $35,000 to have $35,000.
Plan Ownership
A Roth IRA is individually owned. Other than collectibles and life insurance, you can direct your investments however you like. Pre-tax plans can be individually owned, like a traditional IRA, or they can be sponsored by your employer, like a 401(k). Employer-sponsored plans have higher contribution limits and limited investment menus. The 2022 annual contribution limit to a 401(k) plan was $20,500 ($22,500 in 2023) compared to the $6,000 contribution limit for Roth IRAs ($6,500 in 2023).
Which Is Better For You?
While there’s no ideal way to anticipate which will be better for you, Roth IRAs would work best when the tax rates during your working years are lower than your tax rates at retirement. Pre-tax plans would work better when tax rates in your working years are higher than tax rates during retirement.
Contributions
Pre- and after-tax contribution strategies can have a significant impact on how much your retirement account can grow. Consider an example of a 30-year-old in the 24% tax bracket (and an effective rate of 16.52%) who contributes $6,000 per year to a Roth IRA and earns 6% interest. The Roth IRA account will have $714,725 at age 65. The annual contribution represents $7,187 in earnings, or $6,000 after tax at an effective tax rate of 16.52%. A fair comparison with the 401(k) should include the $1,187 of tax savings in the pre-tax contribution. So consider the same person instead who contributed to a pre-tax 401(k) plan which has a higher contribution limit, and who contributes their tax savings, an additional $1,187 per year. Simply because you’re investing a higher amount, at age 65 the 401(k) account balance is $856,233. The 401(k) account has $141,508 more than the Roth IRA.
Withdrawals
Now let’s compare the two plans in the context of you withdrawing $50,000 of retirement income at different tax rates. The figures in the table below are based on an assumption that tax rates increase as your income increases with age. Here’s what the account balances look like 20 years later at age 85 after annual $50,000 (and $50,000 equivalent) distributions, assuming a 6% rate of return.
A Best-of-Both Worlds Option
You don’t necessarily have to choose between a Roth IRA or a pre-tax retirement plan. If you’re married filing jointly, you can contribute to a Roth IRA if your income is less than $214,000 ($228,000 in 2023). The limit for individuals is $144,000 ($153,000 in 2023). Making both Roth and ‘pre-tax’ contributions may be a good overall strategy for your retirement plan.
The Bottom Line
Predicting future tax rates is unpredictable, especially if retirement is many years away. Besides tax rates, here are some other considerations that may help you decide if you should opt for a Roth IRA, or a pre-tax retirement plan, or perhaps both.
What Does Your Employer Offer?
If your employer offers matching contributions, it makes sense to contribute as much as you can to the plan. If you choose a Roth option, your contributions will be allocated to the Roth plan, however your employer contributions will be allocated to the pre-tax plan.
How Much Can You Contribute?
If you can’t contribute the maximum to your employer sponsored plan, a pre-tax option may be a better choice because you’re investing the tax savings. Regardless of future tax rates, you’ll still have more money in your retirement account.
