‘There is no clear answer.’ How to decide between Roth and pre-tax retirement savings accounts

Add this to the list of challenging questions for retirement savers: Should I contribute to a pre-tax or Roth account?

You may not know if you made a wise choice until decades have passed. Fortunately, there are some key factors to help make the decision easier, and situations in which the probability of “success” is greater, according to financial advisors.

“There is no clear answer, so you have to take a leap,” said Ellen Lander, principal and founder of Renaissance Benefit Advisors Group based in Pearl River, New York.

The tax code offers a financial benefit to Americans who contribute to a qualified retirement account like a 401(k) plan or individual retirement account.

The core difference between a pre-tax and Roth account is when savers reap those benefits — and when their taxes come due.

In a pre-tax account, savers get an upfront tax benefit. They don’t pay income tax on their contributions; those funds are deducted from savers’ taxable income, which reduces their tax bill. Instead, they opt to pay tax later when they withdraw funds in retirement.

The opposite is true of a Roth account: Savers pay tax upfront when they contribute money, but don’t pay income tax on withdrawals in retirement.

Taxes are therefore a primary consideration when choosing to save via pre-tax or Roth.

It comes down to this question: Do you expect your tax rate to be higher or lower in retirement?

If higher, it makes sense to save in a Roth account now and pay taxes at your current, lower rate. If lower, saving in a pre-tax account and deferring your tax bill generally makes more financial sense.    

Consider this: If your present and future tax rates are identical, the pre-tax versus Roth choice doesn’t matter from a mathematical standpoint, said David Blanchett, head of retirement research at PGIM, an asset-management arm of Prudential Financial. You’ll end up with the same amount of after-tax retirement savings.

Of course, it’s impossible to know what your future tax rate will be — lower, identical, higher — due to unknowable personal circumstances and future policy adjustments.

“You’re really just making a tax bet,” Ted Jenkin, a certified financial planner and CEO of oXYGen Financial, said of the choice.

But some savers have better odds of winning that tax bet.

Young people in their 20s and 30s are often the best candidates for Roth savings, according to financial advisors.

Since these young professionals are early in their careers, there’s a strong likelihood they’ll earn higher salaries later and have a higher standard of living when they retire. Those higher salaries and income needs may translate to a higher future tax rate.   

“I’d say a Roth always wins out [for younger people],” Lander said.

Jenkin, a member of CNBC’s Advisor Council, “almost always” counsels clients of any age to use a Roth 401(k) or IRA when they’re in the 24% federal tax bracket or lower.

In 2022, this includes single individuals with annual taxable income below $170,050 and married couples below $340,100. Those amounts will increase in 2023.

Spending typically declines in retirement relative to one’s peak expenditures while working. A pre-tax 401(k) or IRA might make financial sense in this case since a lower tax rate may accompany those lesser income needs.

Peak spending is generally from age 45 to 54, when the average household spends roughly $84,000 a year, according to the 2021 Consumer Expenditure Survey. Spending falls to about $52,000 a year, on average, for those age 65 and older.

Of course, it’s not a guarantee your tax rate will fall in retirement.  

Additionally, some people may feel they can only afford to save money for retirement if they get the upfront tax break from a pre-tax account. And someone with high-interest credit card debt or another type of loan may be better-served by a pre-tax retirement account and using the extra money the tax savings leave in their paycheck to help pay down that debt, according to advisors.

Just as financial advisors suggest retirement savers diversify their investments, they also preach the benefits of tax diversification — especially for investors to whom the choice between a pre-tax and Roth account doesn’t seem clear.

Such investors might elect to funnel half their contributions to a Roth and half to a pre-tax account to hedge their tax bet, for example.

“I love the half and half [option],” Lander said. “You’re only half wrong.”

Having two tax buckets presents financial options to retirees.

For example, retirees who are on the cusp of jumping into a higher tax bracket can opt to withdraw money from a Roth account for their income needs. Since a Roth withdrawal doesn’t count toward taxable income, the person wouldn’t jump into a higher bracket.

The same strategy applies to Social Security taxes and monthly premiums for Medicare Part B and Medicare Part D — each of which may increase with income.

A retirement law passed in 2019 — the SECURE Act — makes diversification useful even for wealthier savers, especially those who plan to bequeath retirement assets to heirs, Jenkin said.

The law requires non-spouse beneficiaries like kids and grandkids to withdraw all account assets within 10 years, a much shorter time window than under prior law. Heirs wouldn’t pay income tax on Roth assets but would on the pre-tax withdrawals.

“Even for some wealthier people, I’m starting to hedge bets,” Jenkin said.