Retirement Savings 201: Pre-Tax or Roth?
Not sure what to do? You’re not alone…
So you’ve got a new job, and now you’ve got to make some retirement savings decisions. One of those is whether to use Pre-Tax or Post-Tax income to fund your retirement. Confused about what to do? Don’t be surprised, this is one of the hardest things to calculate, with so many variables and unknowns that the only thing you can be sure of is that things will likely be different than you expect. Whatever anyone tells you, there are only two clear-cut cases where you can be fairly certain of what to do. The rest is a bit more complex retirement savings puzzle.
So what’s the difference?
When it comes to retirement savings options, Pre-Tax and Roth are exact opposites. Pre-Tax contributions go into your account before you pay taxes. When you withdraw the money later, you pay income tax on the withdrawals. Roth contributions go in after you’ve paid tax on your income, but you don’t pay taxes when you withdraw the income later. The definition is simple, knowing what to do is a bit more complicated. You are trying to figure out if it will be more beneficial to pay tax now, or pay tax later on your retirement savings.
It’s not if, but when you pay your taxes
You will never avoid paying taxes on these accounts, the question is when you pay them. Mathematically, it makes no difference. You are using one of two equations: 1) Income x (1 – Tax Rate) x Investment Returns or 2) Income x Investment Returns x (1 – Tax Rate), which your algebra teacher would point out are the same. The only thing that can change is your tax rate now, versus your tax rate later. So here are the easy cases; if you are currently in the lowest tax bracket, your rates can only stay the same or go up, so you pay the taxes now and put the money in a ROTH post-Tax. If you are currently in the highest tax bracket, your tax rate can only stay the same or go down, so you put the money in Pre-Tax.
Will your future income be higher…or lower than today?
Everything else is a bet on how much money you’ll have in the future to draw income off, which is driven mainly by three factors: how long until you start drawing, how much do you have now, and what return you can expect, which in of itself is a factor of how much time you have. The younger you are, the more likely you should be Post-Tax. The more you’ve saved, the more likely you should be Post-Tax. This chart basically helps you determine the likelihood that your tax rate in retirement will be higher than current. If it’s likely to be higher, you’ll want to skew Post-Tax, meaning more than 50%. If it’s likely to be lower you’ll want to skew Pre-Tax, also meaning more than 50%. This is a simple way to think about a problem that you could spend forever on without having a higher probability of being right.
Of course, the WeVest App, and it’s separate retirement calculator, can help you get a good idea of whether your income is likely to be higher or lower in retirement.