If your employer-sponsored retirement savings plan allows pretax, after-tax, and/or Roth contributions, which should you choose?
Pretax: Tax benefits now
With pretax contributions, the money is deducted from your paycheck before taxes, which helps reduce your taxable income and the amount of taxes you pay now. Consider the following example, which is hypothetical and has been simplified for illustrative purposes.
Mark earns $2,000 every two weeks before taxes. If he contributes nothing to his retirement plan on a pretax basis, the amount of his pay that will be subject to income taxes would be the full $2,000. If he was in the 25% federal tax bracket, he would pay $500 in federal income taxes, reducing his take-home pay to $1,500. On the other hand, if he contributes 10% of his income to the plan on a pretax basis–or $200–he would reduce the amount of his taxable pay to $1,800. That would reduce the amount of taxes due to $450. After accounting for both federal taxes and his plan contribution, Mark’s take-home pay would be $1,350. The bottom line? Mark would be able to invest $200 toward his future but reduce his take-home pay by just $150. That’s the benefit of pretax contributions.
In addition, any earnings made on pretax contributions grow on a tax-deferred basis. That means you don’t have to pay taxes on any gains each year, as you would in a taxable investment account. However, those tax benefits won’t go on forever. Any money withdrawn from a tax-deferred account is subject to ordinary income taxes, and if the withdrawal takes place prior to age 59½ (or in some cases, 55 or 50, depending on your plan’s rules), you may be subject to an additional 10% penalty on the total amount of the distribution.
Roth: Tax benefits down the road
On the other hand, contributing to an employer-sponsored Roth account offers different benefits. Roth contributions are considered “after-tax,” so you won’t reduce the amount of current income subject to taxes. But qualified distributions down the road will be tax-free.
A qualified Roth distribution is one that occurs:
- After a five-year holding period and
- Upon death, disability, or reaching age 59½
Nonqualified distributions are subject to regular income taxes and a possible 10% penalty tax. However, because Roth contributions are made with after-tax dollars, a distinction is made between the portion of the distribution that represents contributions versus earnings on those contributions. If at some point you need to take a nonqualified withdrawal from a Roth 401(k)–due to an unexpected emergency, for example–only the proportion of the total amount representing earnings will be taxable.
In order to meet an unexpected financial need of $8,000, Tina decides to take a nonqualified hardship distribution from her Roth 401(k) account. Of the $20,000 total value of the account, $18,400 represents after-tax Roth contributions and $1,600 is attributed to investment earnings. Because earnings represent 8% of the total account value ($1,600 ÷ $20,000 = 0.08), this same proportion of Tina’s $8,000 distribution–or $640 ($8,000 x .08)–will be considered earnings subject to both income taxes and a 10% penalty tax.
However, keep in mind that tapping your account before retirement defeats its purpose. If you need money in a pinch, try to exhaust all other possibilities before taking a distribution. Always bear in mind that the most important benefit of a Roth account is the opportunity to build a nest egg of tax-free income for retirement.
After-tax: For those who are able to exceed the limits
Some plans allow participants to make additional after-tax contributions. This plan feature helps those who want to make contributions exceeding the annual total limit on pretax and Roth accounts (in 2016, the limit is $18,000; $24,000 for those age 50 or older). As with a traditional pretax account, earnings on after-tax contributions grow on a tax-deferred basis.
If this option is offered (check your plan documents), keep in mind that total employee and employer contributions cannot exceed $53,000, or $59,000 for those 50 and older (2016 limits).
Another benefit of making after-tax contributions is that when you leave your job or retire, they can be rolled over tax-free to a Roth IRA, which also allows for potential tax-free growth from that point forward. Some higher-income individuals may welcome this potential benefit if their income affects their ability to directly fund a Roth IRA.1
1In addition to rolling the proceeds to a Roth IRA, participants may also (1) leave the assets in the original plan, (2) transfer assets to a new employer’s plan, or (3) withdraw the funds (which in some cases could trigger a taxable event).
Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2016