When saving for retirement through an employer-provided retirement plan such as a 401(k), one of the most important decisions you’ll face is whether to contribute on a pre-tax or after-tax basis. Each option has tax advantages, and the right choice depends on your financial situation and future tax expectations. Here are tips for deciding which contribution type is right for you.

1. Understanding Pre-Tax and After-Tax Contributions

The key difference between pre-tax and after-tax contributions is when you pay taxes.

• Pre-Tax Contributions: When you make pre-tax contributions to a traditional 401(k), the money is deducted from your paycheck before taxes, reducing your taxable income for the current year. This provides an immediate tax benefit, which can be valuable if you’re in a high tax bracket. However, you will pay taxes when you withdraw the money in retirement, and those withdrawals will be taxed as ordinary income.

• After-Tax Contributions: After-tax contributions to a Roth plan are made with money that has already been taxed. While there’s no upfront tax benefit, the big advantage is that your withdrawals in retirement will be tax-free, provided you meet certain conditions. This can be a great option if you expect to be in a higher tax bracket when you retire or want to minimize your taxable income in retirement.

2. Evaluating Your Current and Future Tax Situation

One of the primary factors in deciding between pre-tax and after-tax contributions is your current tax bracket compared to your expected tax bracket in retirement.

• Higher Tax Bracket Now: If you’re currently in a high tax bracket and expect to be in a lower bracket in retirement, pre-tax contributions may be the better option. You get the immediate benefit of reducing your taxable income now and can pay taxes later when you expect to be at a lower rate.

• Higher Tax Bracket in Retirement: If you think your income (and therefore your tax bracket) will be higher in retirement, making after-tax (Roth) contributions may make more sense. Although you pay taxes now, you’ll benefit from tax-free withdrawals later. This can also be a hedge against any future increases in tax rates.

3. Balancing Pre-Tax and After-Tax Contributions for Flexibility

Contributing to both pre-tax and after-tax accounts can give you flexibility in retirement. This approach gives you more tax diversification, allowing you to decide each year which account to tap into based on your tax situation.

For example, if you’re in a lower tax bracket during the early years of retirement, you can withdraw from your pre-tax 401(k) and pay less in taxes. In years when your taxable income is higher, you can rely more on your Roth 401(k) for tax-free withdrawals, helping you manage your marginal tax bracket.

This balanced approach gives you options to adjust to changes in tax laws or other factors that affect your tax situation.

4. Employer Matching Contributions and Tax Implications

If you contribute to a traditional 401(k), your employer’s match will also be pre-tax. If you contribute to a Roth 401(k), it’s important to understand how your employer’s matching contributions work.

Under current regulations, including changes from the Secure 2.0 Act, employers can offer matching contributions directly to your Roth 401(k) if they choose. However, many employer matches are still made to a traditional pre-tax account by default, regardless of whether you contribute to a Roth or traditional 401(k).

This means:

• If your employer matches into a traditional account: The matching funds will be deposited pre-tax, and you will pay taxes on them when you withdraw the money in retirement.

• If your employer matches into a Roth account: Some employers now offer Roth matching contributions, which would be taxed upfront but grow tax-free and can be withdrawn tax-free in retirement.

It’s important to check with your employer to understand how they structure matching contributions. Either way, try to contribute enough to get the full employer match—it’s essentially free money that can significantly grow your retirement savings over time.

5. Contribution Limits and Strategic Planning

The IRS sets annual contribution limits that apply to both pre-tax and Roth contributions. For 2024, the limit is $23,000 for those under 50, and $30,500 if you’re 50 or older. You can allocate contributions to both pre-tax and Roth accounts within these limits to create a balanced tax strategy.

7. What to Do After Maxing Out Your Contributions

If you’ve already maxed out your 401(k) contributions for the year, you might consider other tax-advantaged savings vehicles:

• Individual Retirement Accounts (IRAs): You can contribute to a traditional IRA or Roth IRA, depending on your income and eligibility. A backdoor Roth IRA conversion might be an option if you’re ineligible to contribute to a Roth directly.

• Health Savings Accounts (HSAs): If you have a high-deductible health plan, an HSA offers triple tax benefits: Contributions are tax-deductible, growth is tax-free, and withdrawals for qualified medical expenses are tax-free. After age 65, HSA funds can be used for non-medical expenses without penalty, though they’ll be subject to ordinary income tax.

• After-Tax Contributions to Your 401(k): Some employer plans allow after-tax contributions above the annual limit, which can then be converted to a Roth within the plan, offering additional opportunities for tax-free growth.

• Taxable Brokerage Accounts: Though not offering the same tax advantages as a 401(k) or IRA, a taxable brokerage account provides significant flexibility. You can invest in a variety of assets without the limitations on contribution amounts or withdrawal rules that apply to retirement accounts. By using strategies like holding investments for over a year to benefit from lower long-term capital gains tax rates, a taxable brokerage account can complement your overall retirement plan and offer additional growth opportunities outside of tax-deferred accounts.

Final Thoughts

Deciding between pre-tax and after-tax (Roth) contributions to your 401(k) is a critical decision in shaping your retirement strategy. By evaluating your current and future tax situation, maximizing employer contributions, and considering long-term factors like RMDs and tax laws, you can make an informed decision.

If you’re unsure which approach is right for you, consulting with a fiduciary financial advisor can help you develop a strategy tailored to your unique circumstances and retirement goals.

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