Pretax vs. Roth: An Introduction to Your Contribution Options in a Workplace Retirement Plan

When most people hear the word Roth, they think of a Roth IRA. However, many are unaware that many employer-sponsored retirement plans such as 401(k)s and 403(b)s offer a Roth contribution option as well. Both pretax and Roth contributions offer unique tax advantages and long-term planning benefits. Understanding the basics of how they work can help you make informed, strategic decisions that align with your financial goals.

What are Pretax Contributions?
Pretax contributions reduce your taxable income in the year you make them, providing an immediate tax benefit. The money in your retirement account then grows tax-deferred, and you will pay income tax on withdrawals during retirement.

This option is often attractive to people who expect to be in a lower tax bracket in retirement—either because they anticipate having fewer expenses or because they plan to replace less income overall. For example, many retirees see a reduction in costs related to debt, housing, or dependents. If that proves to be true, the ability to lower taxable income during high-earning years can be valuable.

Pretax contributions may also be useful for individuals who live in a state with income tax now but plan to retire in a state without it, such as Florida or Arizona. In that case, deferring taxes may help reduce or even avoid future state tax payments on retirement income.

What are Roth Contributions?

Roth contributions are made with dollars for which taxes have already been paid.  In exchange for paying the taxes up front, your contributions and their earnings grow tax-deferred, and qualified withdrawals in retirement are completely tax-free if certain conditions are met. Also, unlike Roth IRAs, higher income levels do not restrict contributions to a Roth 401(k) or 403(b). There are many circumstances where making Roth contributions to a 401(k) can make sense. If you expect to be in a higher tax bracket in retirement or believe tax rates may increase in the future, Roth contributions allow you to pay taxes now and lock in today’s rates. Roth 401(k)s can be especially powerful for younger workers who are just starting their careers and have many years of potential tax-free growth ahead.

Important Reminder About Employer Matching Contributions

Regardless of whether you choose a Roth or pretax option, the most important rule is not to miss your employer’s match, which is typically made in pretax dollars regardless of the method you choose for your own contributions. Matching contributions are free dollars that should not be left unclaimed. Think of the employer match as a guaranteed return on your investment!

Which Contribution Type Is Best?

The short answer is it depends! No matter how hard you try, personal circumstances and future tax law can never be predicted with certainty. Both options have advantages and tradeoffs, and there are circumstances that can favor one over the other. It is also possible to contribute to both a pretax and Roth account simultaneously. This diversification of strategies can provide multiple sources of funds to draw from during retirement, allowing for more flexibility in income planning, tax strategy, estate planning, and Required Minimum Distributions.
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Of course, each of these strategies require considerations that cannot be fully covered in this space. If you would like an answer tailored to your current financial circumstances, career trajectory, and retirement goals, please contact StraightLine to meet with a financial advisor.

​Author

Kyle Zammit, AIF®
Financial Advisor

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