Roth Or Pre-Tax 401(k)?

As an employee of a company, you may have access to a 401(k). A 401(k) is an employer-sponsored (offered) retirement plan that allows you to save money for retirement. Sometimes your employer may provide a match based on a percentage of your contributions.

Your employer may give you the option of saving to a pre-tax account or a Roth account. A pre-tax contribution means that your contributions are made to your account before federal and state taxes are applied to your paycheck. A Roth contribution means that taxes are taken first, then the contribution goes to your account. This is also known as an after-tax contribution.

If you make pre-tax contributions, you avoid tax now but then are taxed when withdrawals are made in retirement. If you make Roth contributions now, you’re taxed today, but withdrawals in retirement are tax-free.

It can make a lot of sense to contribute to your Roth 401(k) for a few reasons.

  1. If you’re in a lower tax bracket now, you’ll pay less tax on your contributions today, and avoid taxes in retirement when taxes rate may be higher, or your income is higher and taxed at a higher rate. This is especially true for young college grads in their first job.
  2. The bulk of your money in your account will eventually be growth of your investments and reinvested dividends. With a Roth account, this will be tax-free when withdrawn at retirement.
  3. Having tax-free income in retirement means that your Social Security benefits may not be subject to taxation; since qualified Roth distributions are not taxable income.
  4. Mentally, not having to pay any (or very little) tax in retirement can be reassuring when it comes to planning for expenses, distributions, and bequeathing.
  5. It may mean that since your Roth distributions are not being taxed, any long-term capital gains may be subject to zero tax.
  6. You may not be able to make Roth IRA contributions (your income may be too high). A Roth 401(k) doesn’t have income restrictions.
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