When planning for retirement, one of the most important decisions you will likely make is which type of retirement account to use. The Roth Individual Retirement Account (IRA) and the pre-tax retirement account are two common options. Both these accounts can offer tax benefits and the chance to accumulate sufficient savings for your retirement. But they work in different ways and can have distinct benefits and disadvantages, depending on your situation.
A financial advisor can help you understand the pros and cons of each and help you decide the best option. This article will explore the critical difference between pre-tax and Roth accounts to help you choose the best fit for your retirement goals and financial situation.
What is a Roth IRA?
AÂ Roth IRAÂ is a tax-advantaged retirement savings account funded with your after-tax dollars. This means that you pay taxes on the money you contribute to a Roth IRA upfront. Your investments then grow tax-free, and you are not liable to pay any tax on your withdrawals in retirement as long as you follow the withdrawal rules set by the Internal Revenue Service (IRS). This feature makes the Roth IRA popular among those who expect to be in a higher tax bracket in retirement, or those who want to leave a tax-free inheritance to their heirs.
Roth IRAs do not have any Required Minimum Distributions (RMDs), so you can keep your money in the account for as long as you like. However, to avoid a 10% penalty and applicable taxes, you must make withdrawals after 59.5 years of age and keep the account active for at least five years before your first withdrawal.
Roth IRAs have income limits for every year, again set by the IRS. Sticking to these limits and not over-contributing is essential, as that can lead to a penalty. The maximum annual contribution limit for 2023 is $6,500 for individuals under 50 and $7,500 for those aged 50 and over. The latter gets an additional catch-up contribution of $1,000.
What is a pre-tax retirement account?
A pre-tax retirement account is the opposite of a Roth IRA or any other Roth account, for that matter. This type of retirement savings account allows you to make contributions with your pre-tax dollars. This means your contributions are made before any tax is taken from your paycheck. This helps you reduce your taxable income for the year. However, your withdrawals are taxed in retirement according to the income tax slab you fall into.
Pre-tax retirement accounts have the same contribution limits as their Roth variants. The rules of pre-mature withdrawal also stay the same, and you attract a 10% penalty if you take a withdrawal before the age of 59.5 and if the account has not been open for at least five years before the first withdrawal. However, unlike Roth accounts, pre-tax retirement accounts have mandatory RMDs. This is a way for the government to tax you as you owe taxes on these funds.
Some common types of pre-tax retirement accounts include the Traditional IRA and employer-sponsored retirement plans such as 401(k)s, 403(b)s, and 457 plans.
Key differences between pre-tax and Roth accounts
Here are some primary differences between Roth IRAs and pre-tax retirement accounts:
| Point of difference | Roth IRA | Pre-tax retirement accounts |
| Tax treatment on contributions | Taxes are deducted in the present on contributions made. | Taxes are not deducted in the present on the contributions made. |
| Tax treatment on withdrawals | There are no taxes on qualified withdrawals made in retirement. | Taxes are levied on withdrawals made in retirement. Moreover, you pay taxes on your earnings as well as the investments you make. |
| RMDs | There are no mandatory RMDs. | RMDs are mandatory from the age of 73 (as of 2023). The RMD value is calculated based on the life expectancy factor published by the IRS. RMDs are mandatory, and failure to withdraw your money at the right time leads to a penalty of 25% of the total RMD amount not withdrawn on time. |
| Growth | Roth IRAs offer tax-free growth on your funds. | A pre-tax IRA or other similar retirement accounts offer tax-deferred growth on your funds |
| Plan ownership | A Roth IRA is individually owned, which means you have greater flexibility to choose your investments, plan administrator, and make adjustments as you like. | A pre-tax retirement account can be individually owned, such as the Traditional IRA, or company-sponsored, like the 401(k), 403(b), and 457 plans. In this case, you may be limited by your company’s investment options and plan features. |
| Repercussions | Your income lowers in the present as you have to pay taxes. This may alter your present lifestyle. | You get to enjoy your complete income without any tax cuts in the present. This may offer you more money to invest, spend, or save. |
Pros and cons of a Roth IRA and pre-tax retirement accounts
Both pre-tax retirement accounts and Roth IRAs are popular types of retirement vehicles. While they share some similarities, they have significant differences in terms of tax treatment, contribution limits, and withdrawal rules. Therefore, reviewing their pros and cons is essential to make a decision.
Pros of pre-tax IRAs and other pre-tax retirement accounts
1. You get to enjoy tax-deductible contributions
Contributions to a Traditional IRA or any other pre-tax accounts are tax-deductible. Hence, you get to reduce your taxable income in the year you make them. This can be an excellent way to save more.
2. You get to enjoy immediate tax savings
Since your contributions are tax-deductible, you can enjoy immediate tax savings in the year you make the contribution. This is a significant advantage as you know exactly how much you will be taxed in the present. Your future tax slabs are unknown to you at this point. There is no guarantee that you will be in a higher or lower tax bracket in retirement. Knowing your current tax dues can be an advantage and help you plan better for the future.
3. You can save more money for the future
The money you save in taxes can be strategically invested in other investments or savings instruments. This can help you focus on other financial goals, like a house’s down payment or a child’s college tuition fund. Since retirement is not the only financial goal you are likely to have, saving tax now and using that money for another cause can be a smart financial move.
4. You may get an employer match
Pre-tax retirement accounts like the company-sponsored 401(k) offer additional benefits like the employer match. With this, your employer matches a percentage of your contributions, ultimately leading to higher investments in your account.
Cons of pre-tax IRAs and other pre-tax retirement accounts
1. Your withdrawals are taxable
When you withdraw money from a Traditional IRA or other pre-tax retirement accounts in retirement, you pay taxes on the withdrawals as ordinary income. As retirement is a time when you would have limited income sources and little to no safety of earning more through a job, income tax can be a burdensome expense. Moreover, if you are in a higher tax bracket in retirement with all your investment returns and other incomes, you may eventually pay more tax than you saved on your contributions.
2. You must remember to take RMDs
Traditional IRAs and other pre-tax retirement accounts require you to take RMDs after a certain age. The RMD rule applies to profit-sharing plans, 401(k)s, 403(b)s, 457(b)s, Traditional IRAs, and other IRA-based options like Simplified Employee Pensions (SEPs), Salary Reduction Simplified Employee Pension Plans (SARSEPs), and Savings Incentive Match Plan for Employees (SIMPLE) IRAs. The RMD age is 73 as of 2023, and you must withdraw the minimum RMD amount according to IRS’s life expectancy factor. In case of failure, you will incur a 25% penalty on the amount not withdrawn. You can withdraw more than the RMD value but never less.
Not only does the mandatory withdrawal create a tax liability for you, but it can also be cumbersome to remember to make the withdrawals every time and calculate the exact value of your RMD. Any mistake you make can lead to penalties.
Pros of a Roth IRA retirement account
1. You get to make tax-free withdrawals
Roth IRA contributions are made with after-tax dollars, so when you withdraw your money after age 59.5, you do not have to pay taxes on it. This offers you a chance to live a stress-free retirement without the burden of taxes. Your retirement nest egg can be utilized entirely on your needs with no unwanted cuts.
2. You do not have to worry about RMDs
Unlike Traditional retirement accounts, Roth IRAs do not require you to take minimum distributions at any age. This allows you to keep your money growing tax-free for as long as you like. You can also choose how much you wish to withdraw from your account. You can let the funds be in the account or make a distribution as you like. This offers you more flexibility, and you get to use the money according to your unique needs and preference.
Cons of a Roth IRA retirement account
1. There are no tax deductions on your contributions
Unlike a pre-tax IRA and other Traditional retirement accounts, contributions made to a Roth IRA are not tax-deductible, which means you cannot reduce your taxable income by contributing to a Roth IRA. This leaves you with a higher tax cut in the year you make the contribution. Because retirement accounts are long-term savings vehicles, you can forgo tax deductions for several years and potentially lower the amount of disposable income in your youth. This can be a disadvantage for those who wish to spend more or lead better lifestyles at this phase of life.
2. You may pay more taxes
If you end up being in a lower tax bracket in retirement, you will eventually pay more tax in your pre-retirement years. This can impact your lifestyle all your life and ultimately lead to fewer savings. On the contrary, if you save tax before, you can invest that money for a better retirement. But saving money after retirement may not offer the same advantage.
Roth IRA: pre or post-tax – Which one to choose?
There is no one-size-fits-all answer, and the decision will largely depend on your financial situation and goals. However, you can focus on the following two things:
1. Think about your tax situation and when you wish to pay tax
If you are currently in a high tax bracket, it may make sense to contribute to a Traditional IRA or any other pre-tax retirement account to lower your taxable income. On the other hand, if you are in a lower tax bracket, contributing to a Roth IRA could be a better option since you will be paying taxes at a lower rate now. However, it is crucial to remember that tax brackets may increase or decrease in the future, and there is no guarantee that your tax liabilities in retirement will be the same as what you presume them to be right now.
2. Consider your goals for investing – retirement savings or estate planning
Another thing to remember is your goals for investing in the retirement account. If you plan to leave your retirement savings to your heirs, a Roth IRA may be a better option as it would not create tax liabilities for your family. A Roth IRA can be inherited without tax if the account has been open and active for at least five years. However, a pre-tax retirement account will have RMDs, which can lead to tax implications for the heirs.
To conclude
Roth IRAs and other pre-tax retirement accounts have unique advantages and drawbacks. Therefore, it is advised to take a look at your income, current and future tax situation, withdrawal plans, and estate planning goals. It is also important to note that you can convert to a Roth from a Traditional account later if you wish. But you will have to pay taxes on the converted amount as it will be treated as part of your taxable income in the year of conversion. Whatever you choose, it can help if you first consult with a financial advisor to identify which option is best for you.
You can use WiserAdvisor’s free advisor match service to look for a suitable financial advisor in your area and know more about the differences between the Roth IRA and pre-tax retirement accounts. All you have to do is answer a few simple questions based on your financial needs, and the match tool will help connect you with 1-3 advisors best suited to meet your financial requirements.
For additional information on the most suitable retirement plan for your specific financial requirements, visit Dash Investments or email me directly at dash@dashinvestments.com.