The Difference Between Roth and Pre-tax Retirement Contributions

When building your retirement savings, your plan might allow you to choose between Roth and pre-tax contributions. But how do you determine which option aligns best with your financial goals? Understanding the difference between these two types of contributions is important when you are deciding on how much you want to contribute to your retirement account.

In this guide, we break down the differences between these different retirement contribution types and provide you with the information you need to decide which option is best for your needs.

Did you know with a Penelope retirement plan you can make both Roth and pre-tax contributions? Get started to learn more. 

Key Differences Between Roth and Pre-Tax Contributions

Understanding the differences between Roth and pre-tax contributions is helpful when deciding what type of contribution you'd like to make to your retirement plan. If your retirement plan offers both Roth and pre-tax contributions, you can choose to split your contributions between them. Let's look at the differences between Roth and pre-tax that could influence your decision-making process.

Tax Implications and Considerations

• Immediate Versus Deferred Tax Impact: Roth contributions have a tax impact now, while pre-tax contributions delay taxes to the future. Your choice should align with your current and anticipated tax situation.
• Tax-Bracket Considerations: If you anticipate a higher tax rate in the future, Roth contributions may be more favorable, as you're paying taxes now at a potentially lower rate.

Withdrawal Rules and Penalties

• Flexibility With Roth Accounts: Roth contributions allow more flexibility with withdrawals, as you can usually withdraw your contributions (but not earnings) without tax or penalty since the principal has already been taxed.
• Penalties for Early Withdrawals: With pre-tax plans, early withdrawals typically lead to a 10% penalty, on top of the income tax you'll owe on the distribution.

Contribution Limits and Eligibility

• Income Impact on Roth Contributions: High-earning small business owners and employees may face restrictions on how much they can contribute to a Roth IRA, while traditional contributions have no such income limits. However, with a Roth 401(k) plan, income limits do not apply.
• Contribution and Deduction Limits for Pre-Tax Plans: While pre-tax retirement accounts have more flexible contribution limits, the deductibility of contributions can be phased out at certain income levels.

Let's dive into each of these contribution types in more detail.

Pre-Tax Retirement Contributions Defined

Pre-tax retirement contributions, also known as traditional retirement contributions, are investments made with money that has not been taxed yet. This means the deposits into the retirement account decrease your taxable income, potentially reducing your tax burden for the year of contribution. The money is allowed to grow tax-deferred, but the IRS will tax you upon withdrawal.

Advantages of Pre-Tax Contributions

• Immediate Tax Savings: Your contributions reduce your taxable income in the year you make them, which might move you to a lower tax bracket and result in immediate tax savings.
• Tax-Deferred Growth: The money grows tax-free until you're required to start taking distributions, typically when you are older and potentially in a lower tax bracket.

Limitations and Considerations

• Withdrawal Restrictions: Early withdrawals before retirement age may incur a penalty and be subject to regular income tax.
• Required Minimum Distributions (RMDs): Once you reach a certain age, you must start taking RMDs, which are taxable and could affect your tax situation. Read more on the IRS website here.
• Income Taxes at Withdrawal: While the initial tax break is appealing, pre-tax contributions are taxed as ordinary income upon withdrawal.

Roth Retirement Contributions Explained

Roth retirement contributions are made with post-tax money, meaning there's no initial tax deduction for contributions. However, qualified withdrawals in retirement, after age 59 ½, are tax-free. This provides a significant advantage for investors who anticipate being in a higher tax bracket in retirement, as the tax rate is locked in at the time of contribution.

Benefits of Roth Contributions

• Tax-Free Distributions: Unlike pre-tax plans, qualified distributions from a Roth retirement plan are free of income tax, providing a known tax situation in retirement.
• No Required Minimum Distributions (RMDs): As of 2024, Roth accounts do not require distributions at any age, giving you more flexibility and control over your finances.

Limitations and Considerations

• No Immediate Tax Benefits: Contributions to Roth plans do not reduce your current tax bill, which can be a downside for those seeking immediate tax relief.
• Income and Contribution Limits: There are income limitations on who can contribute directly to a Roth IRA, and there are also contribution limits based on your income.
• Early Withdrawal of Earnings: If you withdraw earnings before age 59 ½, and do not meet the criteria for a qualified distribution, you may face taxes and penalties.

Start Contributing to Your Retirement Account With Confidence

The choice between Roth and pre-tax retirement contributions involves considering your current financial goals and future plans. As you start planning for your future, consult with a financial advisor to tailor a retirement strategy that aligns with your long-term goals.

Remember, financial planning is an ongoing process—what works best today might not be the optimal choice in the future. Regularly review your retirement savings strategy with a professional to ensure it continues to serve your best interests in light of any changes to your business or personal financial situation. 

If you need a 401(k) plan with both pre-tax and Roth options, talk to one of our retirement specialists to learn more about our retirement plans at Penelope.