401k Contributions Pre-Tax or Post-Tax is Not an Easy Decision
401k contributions pre-tax or post-tax is the conundrum facing many 403b and 401k participants. Plan participants will frequently ask, Should I make my 401k contributions pre-tax or post-tax? They want to know which type of contribution makes the most sense. How should I contribute to my 401(k)? You might get that question a lot from employees, and it’s a good question that can have a significant impact on their future wealth
Here are some ways to help your participants get to their best answer, thus helping employees to make that all important retirement savings decision when asking, 401k contributions pre-tax or post-tax?
Roger Ma, a Certified Financial Planner, writes in Forbes: “… there are no one-size-fits-all solutions.” That’s true — of course, this is only relevant if your organization offers a post-tax (Roth) 401(k) option. The chances of that are good, though; 70% of employers offer a Roth savings option, according to research from Willis Towers Watson. Beyond that, though, every employee’s situation is slightly different and should be treated as such. Mr. Ma outlines the key considerations for employees as they weigh their options when choosing between – 401k contributions pre-tax or post-tax?
One is an employee’s anticipated income tax bracket in retirement. While no one can predict with 100% accuracy which tax bracket they’ll be in during their post-career years, there are factors that can help influence the decision. If an employee is a recent graduate or has only worked part of the year, for example, they might be in a relatively low tax bracket for 2018 (i.e., 10% or 12%, per Ma). However, if they expect to earn more as they get further along in their career, it may make sense for them to make the post-tax (Roth) contributions so they can pay taxes today while they’re in that lower tax bracket. This way they can benefit from tax-free withdrawals when they retire. Conversely, those who are in a higher tax bracket today may want to make pre-tax contributions to save on their tax bill now. Especially if they are more likely to be in a lower tax bracket when they begin withdrawing their assets.
Another deciding factor in the 401k contributions pre-tax vs post-tax (Roth) debate is tax diversification. Ma points out employees typically have three primary buckets where they can hold their investments:
“Pre-Tax: Money is contributed on a pre-tax basis and when withdrawn, funds are taxed at your marginal tax rate.
Roth: Money is contributed on an after-tax basis. Withdrawals at retirement are generally not taxed.
Taxable: Money is contributed on an after-tax basis. Any income and gains from investments are taxed at short-term or long-term capital gains rates, depending on the type of investment and holding period.”
As Mr. Ma notes, spreading one’s investments across all three buckets may be appealing because it provides flexibility to pull money from pre-tax, Roth or taxable accounts, allowing some control over how they are taxed when it comes time to withdraw those assets. Tax brackets impact the required minimum distributions people must take from pre-tax accounts when they reach age 70 1/2; they also have a bearing on Medicare premiums and Social Security benefits, so it’s important for workers to consider those scenarios today so they can manage their money wisely (and hopefully pay fewer taxes) at the time of withdrawal.
The decision to make 401k contributions pre-tax or post-tax is based on individual circumstances. Depending on a person’s income, the decision could even vary year by year. Again, the key factors for employees to consider are their current and future tax brackets, along with the types of accounts in which they hold their investments.
Again, an important point to remember is to encourage your employees to consider their current and anticipated tax situations, remind them to weigh their options carefully, and let them know that what they do this year might be different during the next year. When it comes to 401k contributions pre-tax or post-tax, giving employees the tools and information they need to understand their situation, and encouraging them to be patient and flexible can go a long way toward helping them make informed decisions that fit their unique situation. This ultimately helps them to preserve their wealth at retirement.
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