Pre-tax or Roth Contributions

Choosing Between Pre-Tax and Roth Retirement Plan Contributions

Deciding between pre-tax retirement plan contributions and Roth contributions can significantly impact your financial future. Here are some key considerations to help you make an informed decision:

1. Adjusted Gross Income (AGI) and Eligibility

First, determine your adjusted gross income (AGI) to see if you are eligible to contribute to a traditional IRA or Roth IRA. For 2024, the income limits for contributing to a Roth IRA are:

  • Single filers: Up to $153,000 (phased out between $138,000 and $153,000).
  • Married filing jointly: Up to $228,000 (phased out between $218,000 and $228,000).

For traditional IRAs, the deductibility of contributions depends on your participation in an employer-sponsored retirement plan and your income.

2. Current and Future Tax Brackets

Consider your current tax bracket and the one you anticipate being in during retirement. If you expect to be in a higher tax bracket during retirement, Roth contributions might be advantageous since you pay taxes now at a lower rate. Conversely, if you anticipate a lower tax bracket in retirement, pre-tax contributions could be beneficial as they reduce your taxable income now.

Additionally, consider if you have a pension or other sources of income in retirement that might place you in a higher tax bracket.

3. Asset Allocation: Pre-Tax and After-Tax

Balancing your assets between pre-tax and after-tax accounts is crucial for managing taxes and withdrawals in retirement. This strategy can provide flexibility and potentially lower your tax burden. Remember, required minimum distributions (RMDs) from pre-tax accounts start at age 72, which can increase your taxable income in retirement.

4. Free Cash Flow

Evaluate your free cash flow to decide whether to prioritize debt repayment or retirement contributions. High-interest debt should typically be paid off first. If you have sufficient cash flow, maximizing retirement contributions can significantly enhance your financial security.

5. Backdoor Roth IRA

If you are not eligible for direct Roth IRA contributions and have maxed out your 401(k), consider a backdoor Roth IRA. This strategy involves contributing to a traditional IRA and then converting those funds to a Roth IRA. This approach can provide additional tax-advantaged retirement savings.

6. Tax Law Changes

Current tax laws are set to sunset in 2025, which could result in higher tax rates. It might be wise to make Roth contributions now if you expect tax rates to increase in the future. By paying taxes on your contributions at today’s lower rates, you could save on taxes in the long run.

Estimated Projections and Details

To further strengthen your decision-making process, consider the following projections and details:

  • Current Tax Bracket and Savings: Estimate the tax savings from pre-tax contributions based on your current tax bracket. For example, if you are in the 24% tax bracket and contribute $10,000 to a pre-tax 401(k), you save $2,400 in taxes this year.
  • Future Tax Bracket and Withdrawals: Project your tax bracket in retirement. If you anticipate being in the 22% bracket, converting pre-tax savings to Roth now might save money. For instance, converting $50,000 at a 24% tax rate now versus withdrawing at a 22% rate in retirement could result in different tax outcomes.
  • RMDs and Tax Impact: Calculate the impact of RMDs on your taxable income. For example, at age 72, an account balance of $500,000 would have an RMD of approximately $19,531, increasing your taxable income.
  • Backdoor Roth IRA Strategy: If utilizing a backdoor Roth IRA, consider the tax implications of the conversion. Ensure you have enough funds to cover the taxes due on the converted amount.

By considering these factors and projections, you can make a more informed decision between pre-tax and Roth retirement contributions, ensuring a balanced and tax-efficient retirement strategy.