Roth Account Vs Pre-tax Account: Which One Is Better For You?

When it comes to saving for retirement, you have two main types of accounts to choose from: Roth or before-tax. Each of them provides tax benefits, however their implementations and their timing are different. Choosing among them can influence your long-run salaries and tax burden substantially. This blog post will be focused on the comparison between Roth and Pre-Tax accounts regarding the features, benefits, disadvantages and their suitability. We will also give away some examples and do's and don'ts to let you know which type is best for you.

Key Takeaways

• The Roth Account is funded with after tax dollars, in contrast to the pre-tax accounts which are funded with the before tax dollars.
• With Roth accounts, taxes are paid in advance and withdrawals remain tax-free. For pre-tax accounts, taxes are deferred until withdrawal when they become taxable.
• These Roth accounts differ significantly in that they allow more freedom and have few or no restrictions from pre-tax counterparts.
• Pre-tax accounts are more convenient for those who think that their retirement tax brackets are lower than their working-year ones. On the other hand, from a viewpoint of higher tax brackets applied during one's retirement, a Roth account is more rational.
• The decision will be dependent much on the current and future income, tax circumstance and goals in addition to the preferences that you have.

What Are Roth And Pre-tax Accounts?

Roth and pre-tax are two examples of tax-deferred account that are offered by the government to encourage saving during our working life. They vary on the conditions and period tax benefits are working.

Roth Accounts

After tax dollars fund Roth accounts. People owe taxes on the contributions. Alternatively a Roth account grows tax- free and can be withdrawn tax-free during retirement assuming the owner adheres to the rules.

The two main Roth accounts are the Roth IRA and the Roth 401(k). There are Roth IRAs, individual retirement accounts that you can open, make contributions, and maintain it on your own, regardless of the employment status. Roth 401(k)s are the employer-sponsored retirement plans that give you the option of making either Roth or Roth-pre-tax contributions, or a combination of both.

Benefits of Roth accounts:

• Tax-free retention and distribution. The best part is that the income and the distributions from your Roth account are exempted from income taxes, as long as you satisfy the conditions. That can allow you to greatly decrease your tax burden at the same time, which may be particularly beneficial if you anticipate your retirement years to be taxed more heavily than those of your working years.
• No required minimum distribution (RMDs). Unlike regular accounts, Roth accounts do not have RMDs hence you don’t need to start pulling out money when you reach a certain age. This gives you more control that you can apply either to increase your retirement income or undertake better tax planning.
• More withdrawal options. Roth accounts carry less rules and fewer restrictions for withdrawing than pre-tax accounts. Such is the case of Roth IRAs where you can always take out your contributions (but not your earnings) whenever you want, for any reason whatsoever, without any taxes or penalties. Moreover, it will be possible to withdraw $10,000 of earnings from Roth IRA for qualified first-time home purchase free of taxes and penalties. Roth 401(k)s are also very similar, but contributions cannot be made under these plans unless you leave your employer or reach age 59.5.
• Estate planning benefits. Roth account is a nice tool in passing your wealth to your heirs since they get your Roth account IRA tax-free if they inherit it. This can be a great legacy for your family especially if your income is subject to high taxes.

Drawbacks of Roth accounts:

• Higher taxes upfront. You will owe taxes on the contribution you put in a Roth account since it limits your current income and cash flow. It may be difficult to do so, but this is especially true if you find yourself in the higher tax bracket or have other financial responsibilities.
• Lower contribution limits. Each Roth account receives the same contribution limits as a pre-tax account, but since they are funded with after-tax dollars, they can be considered a variant of investor's savings. As an illustration, if you place $6,000 into a Roth IRA, it equals placing $8,000 into a traditional IRA, at a 25% tax bracket. Such implies that you need to put aside more money if you want to save up with Roth than when you do so with pre-tax.
• Income limits. A contribution limits to Roth IRA does not allow high income earners to fund them directly. In 2024, the income limit for single filers is at $144,000 whereas the limit for the couples filing jointly is set at $214,000. In case you exceed this limit you still have a backdoor option which consists of transferring pre-tax IRA into a Roth IRA; such conversion may produce extra taxes and complicated procedures. Contributions to roth 401(k)s do not go through any income limits, as long as the plan is offered by your employer.

Pre-tax Accounts

Pre-tax accounts are funded through pre-tax dollars, which implies that you there are no tax deductions on you contributions. The monies invested in pre-tax plan grows tax deferred and is taxed at the ordinary rate of income when you take it out of your retirement account.

Traditional IRAs and traditional 401(k)s are the de facto type of pre-tax accounts. The traditional IRA is a personal retirement account that can be opened and contributed to on your own at any time. It also does not matter whether you have a job or not. Typical 401(k)s are employer-based retirement savings plans where you can either select pre-tax (traditional) vs. post-tax (Roth) contributions, or a mix of both.

Benefits of pre-tax accounts:

• Lower taxes upfront. When you deposit pre-tax money in an account, it generates a deduction and reduces your current year income and personal tax. This could be a boon if you're in a high tax bracket or face frequent cash shortages.
• Higher contribution limits. The contribution limits of pre-tax and Roth accounts are the same, however, the latter is a type of account where contributions are made using pre-tax salary which in effect enables more savings. For example, if you deposit $6,000 to a pre-taxed IRA and you have a 25% tax rate, then it's as if you deposited $6,000 into a Roth IRA. So, in other words, you would have to save all compared to a Roth account to be able to reach the same purpose for your retirement.
• There are no income limits. You can put as much money as you would like into a pre-tax IRA, without any income limitations that would theoretically stop you. On the flip side, if you or your partner are provided with a retirement plan in your job, the amount that you can get to deduct as your contribution may be limited or phased out depending on your income. Only the pre-tax 401(k)s do not have earnings limits, but they are accessible if your employer provides them

Drawbacks of pre-tax accounts:

• Taxable revenue and withdrawals. On the other hand, the post-tax account is subjected to taxes on the revenues and distributions of such an account at your ordinary income tax rate. By doing this, you can reduce your retirement income and increase your tax liability especially if you expect to let go of your working job and start enjoying retirement.
• Required minimum distributions (RMDs). In other words, unlike the Roth accounts that have no RMDs, the pre-tax ones do have them. When you are 72 years old, or 70 if you were born before July 1, 1949 you start drawing money from them. The RMD amount will be determined by your account balance, and by your life expectancy, and it will be subject to income taxes and penalties if you don’t take it. This might make you vulnerable when decision making pursuing your retirement requirements as well as tax planning.
• Fewer withdrawal options. Pre-tax accounts, such as SIMPLE IRA and 401(k) have more limitations on taking withdrawals compared to Roth accounts. To illustrate, you typically cannot take any funds from a pre-tax IRA before 59.5 years old unless you qualify for an exception, which include being disabled, medical expenses, and higher education costs. Besides you still have to pay taxes on that amount and a 10% penalty on the amount you withdraw. Pre-tax 401(k)s have similar regulations, but these plans may also provide the opportunity to get a loan or a hardship withdrawal, based on the work arrangement.
• Estate planning drawbacks. Before-tax accounts often turn out to a burden for your heirs, as the tax is payable on the inherited account, and the benefit must be utilized within 10 years. It can seriously lower that asset value for your heirs, particularly for those who are in the higher tax rate.

How To Choose Between Roth And Pre-tax Accounts?

Whether Roth or pre-tax account is the better choice basically depends on making a decision between your current and future income, tax situation, goals and preferences. There is no one-size-fits-all answer, but here are some general guidelines to help you decide:

• If you anticipate being in the lower tax bracket during the retirement than in the working years, pre-tax accounts may be more favorable to you because up front tax savings are much more and then you pay less at a later time.
• In case you anticipate your taxes to be higher in retirement as compared to the time when you were working, Roth accounts could be beneficial to you as you have the ability to pay your taxes in advance and save later.
• Adjusting your investment strategy and knowing the expected tax bracket during your retirement state is necessary if your tax rate per bracket would remain the same as in your working years. Contrary to this, you may find Roth accounts more suitable for their flexibility and estate planning advantages, or pre-tax accounts convenient for their simplicity and the cash flow benefits.
• If you are not sure about your tax position in the future you may want to diversify your retirement savings where part goes to Roth and part goes to pre tax so that you have more options and less risk. For example, in this scenario, you can contribute to both a Roth and a pre-tax 401(k) if they are offered by your employer or you can contribute to an IRA that is tax-deferred and then convert some or all of it to a Roth IRA later on, which will depend on your income and the taxes that you are faced with..

To clarify it, we will now practice by highlighting some examples of how they work in real life. We will suppose that rate of tax is 25% for both working life and retirement period, and a constant return of 7% per annum.

Table

Example 1: Maxing Out A Roth IRA Vs A Pre-tax IRA

Let’s imagine that you are 25 years old and you want to save for your retirement by doing an IRA of $6000 per year, and then decide to retire at the age of 65. You have two options: a traditional Roth IRA or a traditional IRA. What is the number that will fetch you more finances in the future?

• You may select Roth IRA in which case you contribute $6,000 of the post-tax money in a year. At the end of it all, when you retire, your Roth IRA is expected to be worth $1,280,996 and you can withdraw it without paying taxes.
• However, if you decide to go for a pre-tax IRA, you can contribute $8,000 per year in contributions before the tax deductions. By the time you retire, the IRA in which you pre-pay taxes will be worth $ 1,707,995, but you will have to pay taxes on your IRA distributions. How about a tax rate of 25 percent and you'll get a take-home amount of $1,280,996 the same as the Roth IRA..

As you can see, in this example, the Roth IRA and the pre-tax IRA will give you the same amount of money in retirement, since tax rate is the same in both. However, the Roth IRA has few advantages over the pre-tax IRA, such as:

• More flexibility. Withdrawals from a Roth IRA can be made at any time without the influence of taxes and penalties. Another benefit is that they can take out as much as $10,000 worth of earnings which are tax-free and penalty-free, to purchase their first home. This you cannot achieve with a before tax IRA, unless you are in a position to meet the framework for that exception.
• No RMDs. You are not required to take RMD’s from Roth IRA, which means you enjoy more flexibility of retirement income and taxation. Whereas the RMDs of tax-deferred investments like traditional IRAs are required to be taken out, which may force you to withdraw more than you need and pay more taxes.
• Estate planning benefits. In the event you have a Roth IRA, you can pass the account’s assets to your heirs without any taxes provided they take their distributions within the 10 years. Your inheritors will be taxed from your pre-tax IRA that will eventually hinder the legacy you are leaving behind.

Example 2: Splitting Contributions Between A Roth 401(k) And A Pre-tax 401(k)

Let's imagine that you are 35 years old and you need to put away savings for retirement by contributing to a 401(k) plan provided by your employer. You have two options: either a Roth 401(k) or a pre-tax 401(k.). You can also choose to put your contributions in either type of accounts based on your needs. What are the appropriate contributions and allocations allowing to maximize your retirement income?

• • If you pick up a Roth 401(k), you contribute $19,500 every year, with $6,500 of it being an after-tax amount. Over time, your 401(k) Roth will grow to $1,766,787 at your retirement time of age 65, and there is no tax to it.
• • One of the advantages of the Traditional 401k is that one can contribute $26,000 per year, excluding taxes. Your 401 pre-tax will reach $2,355,716 under age 65. Fortunately, you only pay taxes when you withdraw from them. For instance, if we make a 25% tax assumption your after-tax balance would be 1.766.787 which is the same as the Roth 401(k).
• • If you mixed your annual contributions between both types of accounts, then you would put in $13,000 per year to each type after having paid $3,250 in the way of taxes for the Roth 401(K). At the time of your retirement which will be happening at age 65, your Roth 401(k) will have swelled up to $883,394, and you can withdraw that tax-free. The pre-tax $401(k) will end up to be $1,177,858 at age 65 when you take your retirement, on which you have to pay taxes. The amount of after tax remaining is $883,394 for Roth 401(k) and $883,394 for pre-tax 401(k), thus summing the total to $1,766,787 as in other cases.

As you can see, because the tax rate is the same in both cases, all three of the solutions in this example will provide you with the same amount of money in retirement. Nevertheless, there aren't many benefits to dividing your contributions across the two kinds of accounts as opposed to just selecting one, like:

• Tax Diversification. Depending on your needs and tax position, you may have more freedom and options when it comes to how you take money in retirement. When your tax rate is high, you can withdraw funds from your Roth 401(k), and when it is low, you can withdraw funds from your pre-tax 401(k), or the other way around. To maximize your tax credits and brackets, you can also modify your withdrawals. 
• Risk reduction. It is possible to protect yourself from the unpredictability of shifting tax rates and legal modifications. For instance, since you have already paid the taxes in full, owning a Roth 401(k) will benefit you if the rates rise in the future. You will save money on taxes later if you have a pre-tax 401(k) since the rates will drop in the future.

Tips For Choosing Between Roth And Pre-tax Accounts

Some tips to help you choose between Roth and pre-tax accounts, based on your situation and goals:

• Think about your future and present tax brackets. Pre-tax accounts can be more advantageous for you if you anticipate being in a lower tax bracket in retirement than you were throughout your working years. Roth accounts might be more advantageous if you anticipate being in a higher tax bracket in retiring than you were during your working years. You might wish to spread out your savings between the two kinds of accounts if you're not sure or think you'll be in the same tax rate.
• Think on your revenue, both now and in the future. A backdoor Roth IRA plan, which entails converting a pre-tax IRA to a Roth IRA, is an option if you are a high earner and may not be able to contribute directly to a Roth IRA. However, depending on your income and any pre-existing pre-tax IRAs, this could result in additional taxes and problems. If your workplace offers a Roth 401(k), you can also contribute to it because there are no income restrictions on this kind of plan. You can be eligible for the saver's credit, a tax credit for making contributions to retirement accounts, if you have a low or moderate annual income. But this benefit doesn't apply to Roth accounts—it only pertains to pre-tax funds.
• Focus on your financial flow, both now and in the future. Pre-tax accounts may be preferable if you require larger cash flow right now because they lower your current income and tax obligation. Roth accounts may be preferred if you can afford to pay more taxes now because they provide tax-free income in retirement.

·       Table

Conclusion

Empower your financial future with ASAN's expert guidance on Roth and Pre-tax accounts, aligning investments with your goals for true financial freedom.

Ready to take the next step?

Contact Us

📞 Phone: +1(613)-981-7097

🌐 Website: asangroupinc.com

Disclaimer:
The information provided in this blog is intended for general guidance and informational purposes only and should not be considered as professional accounting, audit, or assurance advice. Please consult with a certified professional for specific advice tailored to your situation.