Roth vs Pre Tax – Which one to choose? This is a complicated question, and many people cannot decide while choosing. To sum up, in short, Pre-Tax 401(k) contributions help you by providing an upfront tax break. However, there are tax levies while you withdraw funds. However, you will have to contribute to Roth 401(k) after you contribute to taxes, and later your money can grow tax-free.
In this article, you will learn some of the general details about Pre-Tax contributions and Roth contributions. Furthermore, we will provide you with a Pre Tax Versus Roth 401k contribution, which will help you to choose between these two types of tax contributions. Finally, you will also learn the major pros and cons of both Pre-Tax contributions and Roth contributions. Hence, to learn more, read on through to the end of the article.
Pre Tax Vs Roth: How Do These Contributions Work?
In both pretax and Roth accounts, you receive tax benefits. However, the benefits you get differ. Here are how the Pretax and Roth contributions work in general:
If you want immediate tax breaks, you will need to choose pretax contributions to a traditional IRA or a 401(k). However, the money that you withdraw after you retire will be taxed in this method.
According to Investopedia,
“With contributions made to Roth accounts, the money is included in your taxable income for that year, so you do not see an immediate tax advantage. However, during retirement, you can make withdrawals from a Roth account tax-free, including any gains that your investments may have made.”
If you are young and have a longer investment horizon, the best option for you will be to contribute to Roth accounts.
Major Pros And Cons Of Pre-Tax Contributions
As the article on Investopedia rightly puts it –
“With pretax contributions, your tax advantage is immediate. You can deduct your contributions from your taxable income and lower your tax bill for the year. This can help provide you with the additional cash flow you may need to pay for other expenses.”
The following are some of the major pros and cons of Pre-Tax contributions:
Pros Of Pre-Tax Contributions
Here are some of the major pros of Pre-Tax contributions you must check:
- Pre-tax contributions lower your tax bill for the year, as compared to a traditional IRA.
- Your contributions decide how much you end up saving for your retirement and your taxable income bracket for the year.
- You can take a minimum distribution from the accounts that take pretax contributions at the age of 73 (or 72 in some cases). However, you can get an exception for this rule for the retirement plan at your current employer (if you are still working).
Cons Of Pre-Tax Contributions
Here are a few cons of Pre-Tax contributions you need to be aware of:
- Since you made contributions using your pretax money, once you withdraw the money, it is taxed. The tax amount depends on the tax bracket that you fall on.
- If you are young (having a longer investing horizon), your savings from Roth contributions can be quite higher as compared to pretax contributions.
- As of 2023, you can contribute up to $6,500 to a traditional IRA or up to $22,500 to a pretax 401(k). For people aged fifty or more, the catch-up contributions are $1,000 for IRA and $7,500 for pretax 401(k)s.
Pros And Cons Of Roth Contributions
One of the best uses of Roth contributions is that you will be able to save for your heirs. According to BrightonJones.com,
“As long as your account will have been open for at least five years before your heir takes a distribution, they’ll be able to make those withdrawals tax-free. They won’t need to pay taxes or consider the tax implications of making any withdrawals. You’ll have already taken care of that for them.”
Pros Of Roth Contributions
The following are some of the essential pros of Roth 401(k) contributions:
- Your earnings on your investments can grow free from taxes.
- No matter how big your gains are, you will not need to pay taxes on them while you withdraw funds after you retire. This can be a great advantage for you that can help you pay your expenses.
- You can withdraw your Roth contributions without having to pay any penalties or taxes. However, these do not apply to the earnings in Roth contributions (in which case, you will be taxed).
- There is no minimum distribution amount.
- Designated Roth 401(k) accounts have no income limitations for participation, which is not possible with Roth IRAs.
Cons Of Roth Contributions
Here are a few cons of Roth 401(k) contributions you must be aware of:
- Your tax advantages will get delayed till your retirement if you contribute to your Roth account with after-tax funds and not your traditional account.
- When you are making tax contributions, you will not be able to lower your tax bill for the year.
- You will not get the tax benefit before retirement, even if you have a tight cash flow and you carry a debt of a high rate of interest.
- There are income limits for Roth IRAs. As of 2023, you must have a maximum Modified Adjusted Gross Income (MAGI) of $228,000 if you are married and jointly filing the tax. If you are single, then this amount is $153,000. Hence, you cannot contribute more, even if your income is higher.
- In certain cases, there is an RMD for designated Roth 401(k).
Hope this article was helpful for you in getting a better idea of what Pre-Tax contributions and Roth contributions are and what are the major pros and cons that these have. You can see that in Roth contributions since the money is already taxed, you can withdraw them at your retirement without paying taxes.
Hence, it is up to you which retirement account you want to choose for yourself. The one you choose will impact your return on investment and your budget. Do you have any more recommendations to add regarding Pre Tax vs Roth Contributions? Share your views with us in the comments section below.