Ask Linda: Pre-tax versus Post-tax savings

Dear Linda,

Should I save to my pre-tax 401k at work or my Roth IRA? I cannot fully fund both.

Sincerely,

Super Saver

Dear Super Saver,

To determine which account you should save to, calculate your tax rate today versus your projected rate in retirement. In general, Roth contributions are made with after-tax dollars and distributed tax-free. The 401k is the opposite – contributions are made with pre-tax dollars and distributions are taxed at ordinary income rates.

If you are in a higher tax bracket now than you will be in retirement, save to the pre-tax 401k. If you will be in a higher tax bracket in retirement, save to the Roth IRA.

There are other considerations:
  • Tax laws can change – We don’t know for sure what tax rates will be in the future, therefore, some people prefer to save to both types of accounts to hedge this uncertainty and manage their tax bill in retirement.
  • Employer matching – If your employer offers a match on contributions, save at least enough to the 401k to receive that “free money”.
  • Investment options – If your 401k options are limited and expensive, you may choose to invest in the Roth IRA for the ability to create a custom strategy.
  • Income phaseouts – You may make too much money to contribute to a Roth IRA. You can typically get around this with a backdoor Roth IRA, but saving to a 401k may still be the best option for high earners.
  • Flexibility – Roth IRA’s and 401k’s have different hardship provisions for accessing money earlier than generally allowed (age 59 1/2 with exceptions). Examples relate to education expenses, medical bills and a first time home purchase. Additionally, some 401k’s allow you to take out a loan. While this isn’t necessarily a good idea, it is an option that is not available to you with the Roth IRA.

Even though one savings vehicle may end up being a better choice for you mathematically, realistically, either is fine as long as you are saving enough. Have a fee-only, fiduciary Advisor develop a custom retirement plan to make sure you are on track.

 

 

 

 

 

“Ask Linda” is a monthly personal finance column where the founder of Planning Within Reach, LLC, Linda Rogers, picks one question from her readers and publishes a detailed answer with the hope that it benefits others. If you would like to ask Linda a question, email her or contact her on Twitter.

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