I love planning for retirement. As an advisor, one of the best parts of my job is helping a small business set up a retirement plan, at it can tremendously impact the personal lives of those who give so much of their time and effort to the company. Once a plan is set up, I meet with employees, wherein we discuss:

• Individual contributions;
• Employer match;
• Profit sharing; and
• Investment options within the plan.

After my presentation, I’m normally asked by an employee the following question: “Should I make my contributions pre-tax or after-tax?”

What’s the difference?

When you make traditional contributions to your 401(k), you are funding your retirement with pre-tax income. Here’s an example:

• Lucy earns $50,000 annually.
• Lucy decides to contribute $5,000, pre-tax, over the course of the year to her 401(k).
• When Lucy contributes in this manner, her income is reduced by $5,000. As such, she pays income tax based on a $45,000 salary.
• Lucy has deferred taxes on the $5,000 she contributed to her 401(k). In retirement, when she starts to draw from her savings, she will pay ordinary income tax on this money and its earnings at that time.

On the other hand, if you make Roth contributions, you are funding your retirement with after-tax money. Here’s an example:

• Lucy earns $50,000 annually.
• Lucy decides to contribute $5,000, after-tax, over the course of the year to her 401(k).
• When Lucy contributes in this manner, her income is not reduced in any way. As such, she pays income tax based on her $50,000 salary.
• In retirement, when Lucy starts to draw from her savings, the $5,000 she contributes plus its earnings will be realized tax free because she decided to pay taxes on the front end.

When a Traditional 401(k) Contribution Makes More Sense

A traditional, pre-tax contribution to a 401(k) probably makes sense for most folks. Let’s face it, cash flow can be tight. Mortgage; kids; day care; saving for college; etc. For a number of individuals, it is helpful to take the tax deduction now to help save on taxes and increase cash flow.

Another reason to consider pre-tax investments is if you expect to be in a lower income tax bracket in retirement. For example, let’s assume that you expect your federal effective tax rate to decrease from 32% while working to 24% during retirement. This implies that pre-tax contributions are the better option, as you will pay a higher tax rate now (32%) than you would expect to pay in retirement (24%).

When a Roth 401(k) Contribution Makes More Sense

If you’re a high saver, a Roth 401(k) contribution may make more sense for you. Maxing out a Roth 401(k) places more total dollars into a tax-deferred account than if you were to max out a traditional 401(k).

Let’s say you max out your 401(k) in 2022 by contributing the full amount allowed of $20,500 ($27,000 if you are over age 50). While the $20,500 contribution into a Roth 401(k) is with post-tax dollars, the traditional 401(k) is with pre-tax dollars. In this hypothetical scenario, whether you contributed with pre-tax or post-tax dollars, after 30 years earning 5% annually, you now have $1,360,000 in your retirement account. Here’s the difference:

• If you contributed pre-tax, you must pay ordinary income tax on your retirement funds. Assuming you pay 30% in taxes, a traditional 401(k) will leave you with $953,000 to spend in retirement.
• If you contributed after-tax, you’ve already paid income tax on your retirement funds. Thus, you have a true $1,360,000 tax-free in your retirement account.

This example demonstrates that a Roth 401(k) is probably the better choice for high savers, as you get more total tax-deferred benefits.

Another reason to consider a Roth 401(k) is if you expect to be in a higher income tax bracket in retirement. For example, let’s assume that you expect your federal effective tax rate to increase from 24% while working to 32% during retirement. This implies that the Roth 401(k) is the better option, as you will pay a lower tax rate now (24%) than you would expect to pay in retirement (32%).

Conclusion

Everyone’s financial situation is different, and you should account for differences in state tax treatment, current income, and retirement expectations that influence what is the best choice. If you have questions, reach out to an advisor.

The illustrations herein are hypothetical and for illustrative purposes only. They are not intended to represent the past or future performance or any specific investment. Philosophy of compounding does not guarantee profit or prevent loss. Investment return and principal value will fluctuate and when redeemed the investment may be worth more or less than their original cost. All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities and should not be relied on as financial advice. Past performance is no guarantee of future results. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.

Securities offered through Concourse Financial Group Securities, Inc. (CFGS), Member FINRA/SIPC. Advisory services offered through Concourse Financial Group Advisors, a DBA for CFGS, a Registered Investment Advisor. Davis Wealth Management, LLC is independent of CFGS. Davis Wealth Management, LLC and Concourse Financial Group Securities do not provide legal, tax, or accounting advice.

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