Pre-tax vs. Roth 401(k): Choosing which to use for retirement is more difficult than you might believe.

Whether you’re starting a new job or changing your retirement savings objectives, you may need to decide whether to make pre-tax or Roth 401(k) contributions — and the decision may be more complicated than you think.

While pre-tax 401(k) contributions provide immediate tax savings, the funds grow tax-deferred, which means you’ll have to pay taxes when you withdraw. Roth 401(k) contributions, on the other hand, are made after taxes, but your future gains grow tax-free.

Both options are available in the majority of plans. According to the Plan Sponsor Council of America, which polled more than 550 businesses, over 88% of 401(k) plans offered Roth accounts in 2021, substantially doubling from a decade previously.

Since 2011, the proportion of 401(k) programs that offer Roths has nearly doubled.

While your current and future tax brackets are important considerations, experts say there are others.

“It’s difficult to speak in broad terms because there are so many factors that go into making that decision,” said Ashton Lawrence, partner at Goldfinch Wealth Management in Greenville, South Carolina.

Examine your existing and projected tax brackets.
Experts say one of the most important questions to examine is whether you plan to be in a higher or lower tax bracket in retirement.

According to Lawrence, pre-tax contributions are often preferable for higher earners because of the upfront tax savings. However, if your tax bracket is lower, paying levies now with Roth deposits may be advantageous.

If you’re in the 22% or 24% tax bracket or below, I believe the Roth contribution is worthwhile, presuming you’ll be in a higher tax bracket when you retire.
Roth 401(k) contributions, according to Lawrence Pon, a CFP and certified public accountant with Pon & Associates in Redwood City, California, are often beneficial for younger workers who expect to earn more later in their careers.

“I think the Roth contribution makes sense if you’re in the 22% or 24% bracket or below, thinking you’ll be in a higher bracket when you retire,” he added.

‘Taxes are on sale’ till 2025.
Although it is unknown how Congress will adjust tax policy, numerous features of the Tax Cuts and Jobs Act of 2017 are slated to expire in 2026, including lower tax brackets and a bigger basic deduction.

According to experts, these anticipated changes may also figure into the examination of pre-tax vs. Roth contributions.

“We’re in this low-tax sweet zone,” said Catherine Valega, CFP and founder of Green Bee Advisory in Boston, referring to the three-year window before tax bands rise. “I believe taxes are on sale.”

We’re in this low-tax zone.
While Roth contributions are a “no-brainer” for young, lower-income clients, she believes the current tax situation has made these deposits more appealing to higher-income consumers as well.

“I have people who can get in for $22,500 a year for three years,” Valega said. “That’s a substantial sum of money that will grow tax-free.”

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Furthermore, she claims that recent Secure 2.0 improvements have made Roth 401(k) contributions more tempting to some investors. Roth employer matches are now permitted, and Roth 401(k)s no longer have mandated minimum distributions. Of course, plans may differ depending on which elements companies choose to implement.

Many investors think about ‘legacy ambitions.’
According to Lawrence of Goldfinch Wealth Management, “legacy goals” play a role in deciding between pre-tax and Roth contributions. “Estate planning is becoming a larger part of what people are thinking about,” he says.

Since the Secure Act of 2019, tax planning for inherited individual retirement funds has become more difficult. Non-spouse beneficiaries could previously “stretch” withdrawals across their lives. The “10-year rule” requires them to exhaust inherited IRAs within 10 years.

The withdrawal timetable is now “far more condensed, which might have an impact on the beneficiary, particularly if they’re in their peak earning years,” according to Lawrence.

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However, he believes that Roth IRAs are a “superior estate planning tool” than standard pre-tax funds because non-spouse beneficiaries will not have to pay taxes on withdrawals.

“Everyone has different tastes,” Lawrence continued. “We simply strive to present the greatest solutions for what they’re attempting to do.”

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