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401K Plans: Roth or Pre-Tax and how to choose

Around this time of year, I always get questions on how best to save within a client’s employer 401K plan. Does the client save in the pre-tax, standard and most well-known 401K (e.g. pre-tax) or do they switch to saving in the Roth 401K option. A Roth 401k allows contributions to be made with after-tax dollars, while a pre-tax 401k allows contributions to be made with before-tax dollars. There are benefits to both types of 401k plans, and it is essential to understand the differences to make an informed decision.

The main advantage of a Roth 401k is that withdrawals in retirement are tax-free. Since contributions are made with after-tax dollars, the growth and earnings in the account are not subject to taxes. This is beneficial for individuals who expect to be in a higher tax bracket in retirement because they will avoid paying taxes on the distributions. Pay taxes now at a lower rate and avoid paying taxes when they are in a higher rate. There are also no required minimum distributions (RMDs) for Roth 401k accounts (as of 2023), which can provide more flexibility in retirement planning. On the other hand, a pre-tax 401k allows individuals to reduce their taxable income in the year contributions are made by taking a deduction against the “last dollar earned”, which is at the highest marginal tax rate which lowers their tax bill. However, withdrawals in retirement are subject to taxes, at their then marginal income tax rate (including state), which can be a disadvantage for individuals who expect to be in a high tax bracket in retirement. Regardless, a person should be saving the maximum amount they can for retirement, with the bare minimum being the amount to maximize whatever company match might be provided. Overall, the decision between a Roth and pre-tax 401k should be based on an individual's unique financial situation and long-term retirement goals.

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