After-Tax Roth vs. Pre-Tax Plan Contributions: Which is Right for You?

When it comes to saving for retirement, employees often face a choice between two types of contributions to their retirement plans: pre-tax and after-tax (Roth). Understanding the differences can help you decide which is better for your financial future.

What are Pre-Tax Contributions and Roth After-Tax Retirement Plan Contributions?

Pre-Tax Contributions Most employer-sponsored retirement plans allow you to make pre-tax contributions. This means the money is taken out of your paycheck before income taxes are calculated, reducing your taxable income. These contributions grow tax-free until you withdraw them, at which point they are taxed as ordinary income.

Example: If your annual income is $50,000 and you contribute $3,000 to a pre-tax retirement plan, your taxable income reduces to $47,000 for the year, potentially lowering your tax bill.

After-Tax Roth Contributions Roth contributions, named after Senator William Roth who sponsored the legislation, are made with money that has already been taxed. These contributions grow tax-free, and withdrawals made during retirement are also tax-free, provided they meet certain conditions such as being made after the age of 59½ and after the account has been open for at least five years.

Example: If you contribute $3,000 to a Roth plan, your taxable income remains the same for the year of the contribution, but if the account grows to $10,000 by the time you retire, you can withdraw the entire amount tax-free.

Comparing the Two

Both pre-tax 401(k) and Roth 401(k) contributions have the same IRS limits in 2024, which are $23,000, or $30,500 if you’re age 50 and older. However, Roth 401(k) accounts do not have income limits for contributions like Roth IRAs do.

Tax Implications

• Pre-tax: Lower your taxable income now, pay taxes on withdrawals.
• Roth: No immediate tax benefit, but withdrawals are tax-free.

Withdrawals

• Pre-tax: Taxed as ordinary income.
• Roth: Generally tax-free.

If they pass on to my beneficiary(ies)?

• Pre-tax: Beneficiaries pay ordinary income tax on withdrawals.
• Roth: Beneficiaries inherit the money tax-free.

Key Financial Terms Defined:

• Pre-Tax Contributions: Money contributed to a retirement plan before income taxes are applied, reducing taxable income for the year of contribution.
• Roth Contributions: Contributions made with money that has already been taxed, with the benefit of tax-free growth and withdrawals under qualifying conditions.
• Taxable Income: The portion of your income that is subject to income tax.
• IRS Limits: Maximum contribution limits set by the Internal Revenue Service that one can contribute to a retirement plan annually.
• Ordinary Income: Income earned through employment, certain investments, and other sources that is taxed at the IRS’s regular rates.
• Beneficiaries: Individuals designated to receive benefits from a retirement account or other financial accounts upon the account holder’s death.