How to choose between Pre Tax Retirement Accounts (401k and Traditional IRA) and Post Tax Retirement Accounts (Roth 401k and Roth IRA)

Choosing between pre-tax and post-tax (or Roth) retirement accounts is a major decision that can significantly impact your financial future. The core difference lies in when you pay your taxes: either on the way in or on the way out. I speak about this a bit in my recent YouTube Video (video editing is a work in progress).

Pre-Tax Contributions (e.g., Traditional 401(k), Traditional IRA)

• How it works: You contribute money to your retirement account before taxes are taken out. This reduces your taxable income for the current year, giving you an immediate tax break. Your money grows tax-deferred, meaning you don't pay taxes on the investment gains as they occur. However, when you withdraw the money in retirement, both your original contributions and all the investment earnings are taxed as ordinary income.

• Key benefit: An immediate tax reduction. This can be very appealing if you want to lower your current tax bill.

• Best for:

  • People in a higher tax bracket now than they expect to be in retirement. The logic is that you get a tax deduction at your higher current rate and pay taxes later at a lower rate.

  • High-income earners. Pre-tax contributions can significantly lower your taxable income, potentially pushing you into a lower tax bracket. Lowering your tax brackets due to retirement account can lead to significant current year tax savings.

Post-Tax (Roth) Contributions (e.g., Roth 401(k), Roth IRA)

• How it works: You contribute money to your retirement account after taxes have been taken out of your paycheck. This means your contributions don't reduce your current taxable income. The money then grows completely tax-free. When you withdraw the money in retirement (as long as you meet certain requirements, like being over 59½ and having the account for at least five years), both your contributions and all the investment earnings are tax-free.

• Key benefit: Tax-free withdrawals in retirement.

• Best for:

  • Younger workers. If you're early in your career, your income and tax bracket are likely to be lower than they will be later in your career or in retirement. Paying a smaller tax bill now to have tax-free withdrawals on a large, long-term nest egg can be a powerful strategy.

  • People who expect to be in a higher tax bracket in retirement. This could be due to a variety of factors, such as receiving a pension, having other taxable income streams, or simply the possibility of future tax rate increases.

  • High-income earners who don't want to deal with Required Minimum Distributions (RMDs). Roth IRAs do not have RMDs during the account holder's lifetime, providing more flexibility for passing on wealth to heirs.

How to Choose: A Simple Framework

The primary question to ask yourself is: Do you think you will be in a higher or lower tax bracket in retirement?

• If you believe you'll be in a lower tax bracket in retirement, pre-tax accounts are likely a better choice to save more money now when compared to later.

• If you believe you'll be in a higher tax bracket in retirement, Roth (post-tax) accounts are likely a better choice (this is actually more rare - normally your W-2/Active Income years will be much higher than your retirement/passive years)

• Roth IRA’s have been all the hypes the last few years due to social media, youtubers, and other courses being sold. The truth is, its a case by case basis and varies depending on each individuals tax situation and retirement strategy.

Other Factors to Consider

• Your current income: High earners may find the immediate tax deduction from pre-tax contributions more valuable. However, a Roth IRA has income limits, which may prevent high-income earners from contributing directly.

• Employer match: Some employers only match contributions to a traditional (pre-tax) 401(k), while others may match both. Make sure you understand your employer's plan to take full advantage of any free money.

• Diversification: You don't have to choose just one. Many financial advisors recommend a combination of both pre-tax and Roth accounts. This provides a "tax diversification" strategy, giving you flexibility to withdraw from whichever account is most advantageous based on your tax situation in retirement.

• Future tax laws: No one can predict the future of tax laws with certainty. By having both pre-tax and Roth funds, you hedge your bets against a change in the tax landscape.

Ultimately, the best choice depends on your individual circumstances, including your age, income, and future financial goals.