An Introduction to Pre-Tax vs. Roth Savings

In 1997, as part of the Taxpayer Relief Act, Delaware senator, William Roth, helped establish the Roth account. In the <25 years since its creation, it has become widespread.

Pre-Tax vs. Roth 101:

The main difference between these two types of account is when the dollars are taxed—at contribution or withdrawal.

Pre-Tax savings are not taxed upon contribution; they are taxed at withdrawal. Roth savings are taxed upon contribution; withdrawals are not taxed.

Example 1: Zevon is single and earns $100,000 gross income. For simplicity, his marginal tax rate is 30%—for every additional dollar earned, 30 cents go to Uncle Sam and 70 cents go into his pocket. If Zevon contributes $10,000 to his 401(k) Pre-Tax, he would decrease taxable income from $100,000 to $90,000 and save $3,000 in tax (30% of $10,000). If, instead, he contributes $10,000 to a Roth 401(k), he would pay that $3,000 in tax this year.

Tax Zevon Pays

This, however, is not the full story. While saving Pre-Tax allows you to decrease current taxable income, you are still taxed at ordinary income rates when withdrawing funds—usually, during retirement. For Roth savings, you “take the hit” up front and later withdrawals are not taxed.

Example 2: When Zevon retires, he rolls over his Pre-Tax & Roth money into a Traditional IRA and Roth IRA, respectively. He is again at the 30% tax rate. After being confined to his home for 1-year due to COVID-19, he decides to splurge and take a trip to Costa Rica costing $10,000. If Zevon withdraws the funds from his Traditional IRA, he would pay $3,000 in taxes (30% of $10,000). If he withdraws funds from his Roth IRA, he would pay $0 in tax.

Tax Zevon Pays

Because Zevon’s tax rate is the same during his working and retirement years, Pre-Tax and Roth savings are equally monetarily beneficial. The preference for one or the other comes when there is a disparity between current and future tax rates.

Example 3: During retirement, Zevon is now at a 20% tax rate. Withdrawing $10,000 from his Traditional IRA, he pays $2,000 in tax (20% of $10,000). Withdrawing money from his Roth IRA, he would still pay $0 in tax. There is opportunity for $1,000 tax savings by contributing Pre-Tax during working years, rather than Roth.

Tax Zevon Pays

While current vs. future tax rate is a main consideration, there are other factors to weigh.

8 Other Factors:

1. Peak Earning Years - For Professionals in their peak earning years, it typically makes sense to save Pre-Tax, as you would expect to be in a lower tax bracket when withdrawing funds. Currently, for MN residents, the top income tax rates are 37% federal and 9.85% MN (46.85% total). In other words, nearly half of every additional dollar earned goes to taxes. In this case, Pre-Tax savings would likely be advantageous over Roth.
   
   
2. Young Professionals - It is often favorable for young professionals to save via Roth before hitting peak earning years, because tax account type diversity can enable future planning opportunities e.g., combining Pre-Tax and Roth withdrawals to manage your tax bracket during retirement, realize Long-Term Capital Gains at 0% federal rate, etc.
   
   
3. Required Minimum Distributions - Unlike Traditional IRAs, Roth IRAs are not subject to Required Minimum Distributions (RMDs) at age 72. Having all funds Pre-Tax can increase the RMD amount pushing you into higher marginal income tax brackets.
   
   
4. Inheritance - Since there are no RMD requirements for Roth IRAs, they can be an ideal account to leave to heirs. Moreover, if your beneficiary is in a high-income tax bracket, withdrawals can be taken tax-free.
   
   
5. Retiring to Warm Weather - States like Arizona and Florida have lower income tax rates than Minnesota, which can make Pre-Tax savings beneficial.
   
   
6. Conversion Flexibility - You can convert Pre-Tax funds to Roth at a later date giving Pre-Tax savings flexibility. This is advantageous for low-income years e.g., time between retirement and starting Social Security.
   
   
7. Employer Match - Employer contributions are Pre-Tax, so if you receive a match and save via Roth, you automatically accrue tax diverse assets.
   
   
8. The Middle Way - You do not need to select 100% Pre-Tax or Roth. There is typically an option to allocate a percentage Pre-Tax and a percentage Roth.

Selecting between Pre-Tax and Roth savings depends on your unique circumstances and priorities. Like most things in life, the answer is not cut and dry. Hopefully, this has helped clarify the ins-and-outs, so you can make this decision with confidence.

- Your Team at PrairieView