Pre-tax vs. Post-tax Investing: How to Choose

September 18, 2019

What’s better, before tax or after tax investing? Does it matter?

More and more employers are offering the option of directing retirement savings into a traditional 401(k) account or into a Roth 401(k) account. In a traditional 401(k) account, contributions are made before tax. Contributions to your 401(k) are deducted from your earned income before taxes are taken out of your paycheck. Alternatively, if you choose the Roth 401(k) option, your contributions are made from your paycheck after taxes have been taken out.

Let’s look at two examples and see what happens to the final value of each type of retirement saving account.

Traditional 401(k)

Suppose our friend Lucy Lucky got a one-time bonus of $1,000. Since she is very thrifty, Lucy wants to save her bonus in her retirement account. Lucy’s current tax rate is 24%. If she contributes her bonus to a traditional 401(k) account, she will not pay taxes on the contribution. The full $1,000 goes into her 401(k) account and earns 5% per year compounded annually over the next 30 years. By the time she retires, she has $4,321.94 in her 401(k).

One thing to keep in mind, though, is since she contributed on a pre-tax basis, she has to pay income taxes on the withdrawal. If her tax rate remained at 24% at retirement, her net income from her 401(k) account would be $3,284.67.

Roth 401(k)

Here’s the alternative scenario. Lucy takes the $1,000 and pays taxes at 24% on her bonus. She contributes the rest—$760—to her Roth 401(k) plan. If that amount earns 5% per year compounded annually over 30 years, it will grow to $3,284.67. Since she already paid taxes on the amount she contributed and kept her balance in the account for more than five years, she will not have to pay taxes on the principal amount or the earnings when she withdraws it in retirement.

But wait! Both the traditional and the Roth 401(k) plans have the same final value.

 

Tax Me Later

Tax Me Now

 

Traditional 401(k)

Roth 401(k)

Lucy’s Bonus

$1,000

$1,000

Tax at 24%

N/A

$240

Contribution

$1,000

$760

Value after 30 years

$4,321.94

$3,284.67

Withdrawal Tax at 24%

$1,037.27

N/A

Final Value

$3,284.67

$3,284.67

It’s important to consider your expected tax bracket at retirement

The above scenario makes one BIG assumption—that your tax rate will be the same when you are contributing and when you withdraw your money in retirement. While there are some unique features of the Roth option that may drive your decision, when it comes to taxes, the important factor is whether you anticipate your taxes to be higher or lower in the future than they are now.

If you are in a low tax bracket now but anticipate it to increase in the future, you should consider a Roth 401(k). If you expect your tax rate to decline in the future, then consider a traditional 401(k).

If you are a PERA member whose employer has adopted the Roth option in the PERAPlus 401(k) or 457 Plan, then you have the option to choose between contributing before or after tax. This fact sheet will help you compare the differences.