What are Pre-Tax or Roth Contributions?
Pre-tax contributions are contributions that require you to pay tax on any money that is withdrawn from your retirement account. Roth contributions require you to pay your taxes now instead of on money that you withdraw from your account. To choose between pre-tax or after-tax contributions, you will need to compare the tax rates of now or later. However, tax rates change so it is not always easy to calculate what your tax rate will turn out to be by the time you choose to retire.
Pre-Tax vs. Roth Benefits
If your pay is more likely to remain stable and you are more likely to retire faster, you should side with pre-tax contributions. During the years when you must pay less taxes, you should take from a pre-tax account in order to pay the taxes withdrawn from retirement. If you are expected to have a changing salary and have more than ten years left in your career, you should choose Roth contributions. If you are going to pay a lot of taxes during the other years then you should withdraw from the Roth account and pay off the taxes then.
However, you have the option to choose both in case you want to play it on the safe side. You could contribute some money towards pre-tax and the rest towards Roth. Both tax contributions don’t change the amount that your employer gives to your 401K since their contributions are considered pre-tax regardless of your plan. Since there is no right or wrong answer when choosing a plan, there is no pressure and you can’t go wrong with trying out new accounts. Regardless of which kind of 401K plan you choose, federal law reaches the limit of its contributions at $17,500 for those under 50 and $23,000 for those 50 or older.
The general rule of thumb is listed above based on how many tax deductions you will have throughout the year, if you expect to have to raise, and how long you have until you will retire. Since there is no definite way of calculating what your tax contribution rate will be due to the government being able to change it, it is advised that you have a pre-tax or Roth account to use for different years, preferably both. This way there are less restrictions in what you can withdraw from an account based on how many taxes you will pay and when your employment or salary changes. This will help you be able to fall back onto either account since neither affect your employer’s 401K contributions. There is a trend of younger workers converting their traditional 401K balance to a Roth 401K balance through a fiscal cliff deal despite the IRS’s efforts to diminish these actions. Although there were previous rules that allowed for those under the age of 59 ½ to convert their balances to Roth, those are no longer in place. However, the common idea seems to be to pay your taxes now and live tax-free later when you retire.