When it comes to retirement plan savings, many people wonder whether it is better to invest pre-tax dollars or after-tax dollars. May 401(k) plans offer the option of traditional pre-tax deferrals and after-tax Roth deferrals. The answer to this question, unfortunately, is not simple. It depends on many factors.
It is important to understand the difference between pre-tax deferrals and Roth deferrals. Traditional, pre-tax deferrals decrease your taxable income now. That deferrals is invested in the 401(k) plan. Then you withdraw the money at retirement, or at the time of another “distributable event”, that original deposit and any earnings on that deposit that have accumulated over the years is all taxable at that time.
On the other hand, when you opt for Roth deferrals, that deferral amount is withheld from your pay now, and is included in your taxable income now. Because you are paying income tax now, you will not need to pay income tax in the future when the money is withdrawn from your 401(k) plan. An additional benefit to the Roth deferrals is that if you satisfy some requirements, the earnings that have accumulated over the years on that Roth investment are also available to withdraw tax free at retirement (or at the time of another “distribute event”).
In order to decide between Roth or traditional deferrals (or both), you need to look at:
- Your current taxable income. It may be beneficial to decrease taxable income if you are close to phasing out of some income tax deductions or tax credits. It may be beneficial to decrease current tax liability due to current cash flow.
- You also need to consider what you expect your tax situation will be at retirement. Will you be in a higher or lower tax bracket?
- If you are starting young and expect your deferrals to accumulate many years of earnings, you may consider Roth, since those earnings could be significant and will be tax free at retirement.
For IRA’s, remember you still have time to make your tax deductible IRA contribution for 2016 of up to $5,500 ($6,500 if you are over age 50). The deadline is April 17, 2017. There are other requirements. Ask your tax preparer or give us a call to see if you qualify.
Every situation is different and needs consideration. For more information on this topic, please contact Anne Christian, CPA at firstname.lastname@example.org or by phone at (314) 576-1350.