Should You Contribute Pre-tax or Roth?

September 15, 2016

That’s one of the most common questions we get. For example, I recently received the following email: (My response follows.)

I am a 26 year old in my fourth year as a police officer. I’ve been contributing to my employers 401a and deferred comp programs for about 3 years. My contributions have been Roth and after reading your article, I’m wondering if that’s the best option for me. I have a part time job at the local mall that matches 5% of pre tax contribution and I max out there as well. I don’t plan on using the money until retirement, so should I switch my main employer to pre tax as well? This year I’ll make around 60-70k, but next year I’ll probably make around 80k. My goal is to save near a million dollars for retirement and I’m not quite sure how to figure my retirement income. Can you guide me in the right direction?

First of all, great job on contributing to all those retirement accounts at such a young age! The earlier you can save for retirement, the longer that money will be working for you. This will definitely put you in a much better position for retirement.

The basic decision is whether you’d rather pay taxes on your savings now (Roth) or when you take them out of your retirement account (pre-tax). Assuming you’re single, you would currently be in the 25% tax bracket so every dollar you put in those retirement accounts pre-tax is avoiding a 25% tax rate. If you retire with a million dollars, you could safely withdraw about 4% or $40k a year. In addition to the $28k of Social Security benefits you’re projected to receive at your normal retirement age of 67, your $68k of total retirement income would put you in the same 25% tax bracket at retirement.

Not all your retirement income would be taxed at 25% though. Based on your total retirement income, only 85% or about $24k of your Social Security benefits would be taxable. At least about $10k of your income wouldn’t be taxed because of the personal exemption and standard deduction so your taxable income would be no more than about $54k. Using today’s tax rates (which are adjusted for inflation), the first $9,275 of taxable income would be taxed at 10%, the next $28,374 would be taxed at 15%, and only the last $16,351 would be taxed at that 25% rate. As a result, your average or effective tax rate in retirement would actually be about 17%.

Of course, this assumes that you don’t have a lot of deductions like mortgage interest that would go away by the time you retire. It also assumes that the tax code stays the same. If your effective tax rate ends up being higher in retirement, you would be better off with a Roth account.

Confused? One simple solution would be to diversify by contributing pre-tax to your employer’s retirement accounts as well as to a Roth IRA. That’s because the Roth IRA has the additional benefit of the contributions being available anytime without tax or penalty. It may also be helpful to have some tax-free money in retirement to qualify for higher health insurance subsidies if you decide to retire before you’re eligible for Medicare at age 65.

Don’t overthink it though. Whichever option (or combination of options) you choose, the most important thing is that you’re contributing for retirement. The less optimal option is still much better than not saving at all.