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Choosing the tax advantage you want from your retirement savings plan can have a significant impact on your return on investment (ROI) and current budget. Some plans offer tax advantages by allowing you to deduct the contributions from your taxable income in the year you make them. You can make contributions with after-tax income to other plans such as Roth individual retirement accounts (Roth IRAs) and Roth 401(k)s.
You can also split your contributions between pre-tax and after-tax accounts. Each type of tax advantage has its pros and cons.
Key Takeaways
- Choosing the right retirement account can impact your return on investment and your budget.
- You can make contributions to a tax-advantaged retirement fund with pre-tax or after-tax income.
- Traditional individual retirement accounts and 401(k)s generally allow you to deduct your contributions from your taxable income in the year you contribute.
- The income you contribute to Roth accounts is taxed at the time you make contributions so you can withdraw these contributions without paying taxes on the money.
- You must be at least age 59½ to withdraw funds from a traditional IRA or 401(k) account with no penalties although some exceptions exist.
How Pre-Tax and Roth Contributions Work
You can enjoy a tax benefit whether you make pre-tax contributions to a traditional account or after-tax contributions to a Roth account. The tax advantage will depend on which type of account you choose.
Pre-Tax Contributions
Your tax advantage is immediate if you make pre-tax contributions. You can deduct your contributions from your taxable income in the year you make them and reduce your tax bill for that year. This can help provide you with additional cash flow you may need for other expenses.
You can make pre-tax contributions to a traditional IRA or 401(k). The money and everything it earns while remaining in the account is taxed as income according to your income tax bracket at the time you withdraw your funds in retirement.
A rule applies to traditional IRAs, however. The tax deduction for your contributions may be limited or unavailable if your income is above certain limits and you or your spouse have a retirement plan at work. You would still enjoy tax-free growth of your contributions after they’re in your traditional IRA until the money is withdrawn, however.
You can’t withdraw money from a traditional retirement account before age 59½ or you’ll face penalties. You must also begin taking required minimum distributions (RMDs) by a certain age. The rules change based on your age:
- You must begin taking RMDs at age 73 beginning April 1 of the following calendar year if you reach age 72 after Dec. 31, 2022.
- RMDs otherwise begin at age 72 beginning April 1 of the following calendar year.
Important
Numerous banks and credit unions provide free online calculators to determine the difference you’d realize in savings between a pre-tax traditional IRA and an after-tax Roth IRA.
Roth Contributions
The money you contribute to a Roth account is included in your taxable income for that year so you don’t see an immediate tax advantage. You can withdraw your contributions to a Roth IRA at any time, however, because you’ve already paid taxes on the money.
You must wait until you reach age 59½ and have held the account for five years or longer before you can also withdraw your Roth earnings tax-free. These withdrawals are referred to as qualified distributions. Roth IRAs don’t require RMDs or any withdrawals until the death of the owner of the account.
A Roth account that’s made with after-tax funds can potentially offer more tax advantages in retirement to investors with a longer investing horizon or those who have more time for their investments to grow. Investors won’t have to pay taxes on the money when they withdraw it in retirement even if a portfolio makes significant gains.
Income thresholds apply but there’s a Roth backdoor strategy that allows taxpayers at all income levels to convert traditional IRA funds to Roths.
Fast Fact
Roth IRAs don’t have required minimum distributions during the owner’s lifetime. You can keep your funds there growing tax-free until your death if you can afford to do so. Your account will then be cashed out and passed to your heirs.
Advantages and Disadvantages of Pre-Tax Contributions
Advantages
The main advantage to making pre-tax contributions to a traditional IRA or 401(k) is that it generally lowers your tax bill for the year in which you make them. How much you end up saving depends on the amount you contribute and your tax bracket for that year.
You must typically begin to take minimum distributions starting at age 73 or 72 from these accounts. The exact age depends on the year you were born. You might qualify for an exception to this rule for a retirement plan with your employer if you’re still working but the exception would apply only to this plan.
Disadvantages
All money you withdraw from a traditional IRA during retirement is taxed because you made your contributions using pre-tax dollars. The amount you’re taxed will depend on the tax bracket you fall into in the year you take the distributions.
The savings you could secure in retirement by contributing to a Roth account now could be substantially more than the savings you would get with pre-tax contributions if you’re younger with a longer investing horizon.
Contribution limits for IRAs and 401(k)s are determined by the IRS and change every year, as are catch-up contributions for those aged 50 and older.
There are no income limitations for contributing to a traditional account, but the deductibility of traditional IRA contributions can be affected by whether you or your spouse has a retirement plan at work.
Advantages and Disadvantages of Roth Contributions
Advantages
The greatest benefit of Roth accounts is that they allow the earnings on your investments to grow tax-free. You won’t have to pay taxes on your gains when you withdraw the funds in retirement no matter how significant they may be as long as you’ve reached age 59½ and have held the account for five years or longer or you’re disabled. Tax-free income in your retirement years can be a tremendous advantage in helping you pay your expenses.
You may be taxed and may have to pay a penalty if you withdraw earnings without meeting these requirements. You can withdraw any contributions you make to your Roth accounts without penalties or taxes at any time, however.
Roth IRAs have no required minimum distributions. Designated Roth 401(k) accounts have no income limitations for participation unlike Roth IRAs.
Disadvantages
The major disadvantage to contributing to a Roth account with after-tax funds rather than to a traditional account is that your tax advantages will be delayed until your retirement years. You can’t lower your tax bill for the year in which you contribute. Not getting an immediate tax benefit can be a significant downside to contributing to a Roth if you have a tight cash flow and carry high-interest debt.
Another potential downside is that Roth IRAs have income limits. If your income falls within a certain range, you may only contribute a reduced amount. If your income is higher than the upper threshold of your filing status, then you may not contribute at all. These limits change every year, so stay up to date on the IRS guidelines.
Designated workplace Roth 401(k) accounts don’t have RMDs provided that you’re not a 5% owner of the issuing company.
Cons
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After-tax dollars delay your tax benefits
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Income thresholds limit who can contribute
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Designated Roth 401(k)s have an RMD in certain cases
Can You Make Both Pre-Tax and Roth Contributions?
You can make contributions to both a pre-tax traditional account and a Roth account, but your total contributions can’t exceed the IRS maximum contribution limits for each type of account. You could split the contribution limit between a traditional 401(k) and a designated Roth 401(k).
Can You Max Out Both Types of Accounts in One Year?
You can’t double your contribution by putting the full annual limit into a traditional IRA and a Roth IRA. The IRS sets one combined limit that applies across all of your IRA accounts. You can, however, divide that amount across all of your IRAs as you please. With 401(k)s, the same rule applies. There is one overall contribution limit, where you can choose how much goes into a traditional 401(k) and a Roth 401(k).
Can You Switch From a Traditional IRA to a Roth IRA?
You can roll funds from a traditional IRA into a Roth IRA. This can be a good strategy if you expect your tax bracket to be higher in the future but you’ll owe tax on any amount you convert. You may want to consult with a tax advisor before using this strategy.
The Bottom Line
The key to saving for retirement is to start as soon as possible. Choosing the right type of retirement plan can help you meet your financial goals whether it uses pre-tax money, offers after-tax contributions, or both. Consider consulting a financial advisor for guidance on which type of plan best suits your needs.
