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October 23, 2024

Retirement planning: pre-tax 401(k)s vs. Roth 401(k)s

Summary

It’s your first few weeks on a new job, and one of the items on the to-do list is to enroll in your company’s 401(k) plan. If you elect to contribute to this plan, you’ll have to decide what contribution strategy is best suited for you. Whether you're just starting to save or looking to diversify your retirement portfolio, understanding your financial options is essential. In this blog post, we'll introduce you to the basics of the 401(k) accounts, explore pre-tax and Roth strategies, and highlight the benefits of each.

What is defined contribution plan?

A company defined contribution plan is a type of retirement plan in which an employer, an employee, or both make regular contributions to an account designed for the employee to save for retirement. The investment risk is borne by the employee and contributions are typically made in a variety of options, such as stocks, bonds, or mutual funds. The most common type of company defined contribution plans are 401(k) plans, 403(b) plans, 457(b) plans, Savings Incentive Match Plan for Employees (SIMPLE) plans, Simplified Employee Pension (SEP) plans, and profit-sharing plans.

What is a 401(k)?

The 401(k) is a type of savings plan designed to help you save for retirement while offering certain tax advantages. Unlike regular savings vehicles, 401(k)s are specifically intended for long-term retirement savings, and they come with rules and regulations that encourage you to keep your money invested until you reach retirement age. These plans can only be opened with a qualifying employer, while other defined contribution plans like the 403(b) plan are offered mainly by public schools, universities, and certain tax-exempt organizations.

Contributions can be made on a pre-tax or post-tax basis (Roth) and can be invested. Plan participants may only have one defined contribution plan per employer and are subject to withdrawal rules. As the funds are meant to be saved for retirement purposes, early withdrawal before the age of 59 ½ may result in a penalty and tax bill.

What are pre-tax or traditional contributions?

Pre-tax--sometimes referred to as traditional--contributions are funds taken out of a participant’s wages or paycheck before taxes. A plan participant who has earned income from an eligible employer offering a 401(k) option may participate. These funds will grow tax-deferred until the user reaches the age of 59 ½--the key word being “deferred” here, as the Internal Revenue Service (IRS) will receive a portion when you withdraw the funds for retirement expenses. Withdrawals are taxed as current income, meaning that taxes are based on the effective rate of the year you use your retirement funds.

I once heard an advisor refer to the pre-tax portion of a 401(k) as a joint account with the IRS, but you won’t know what the joint account owner’s (IRS) share will be when the funds are distributed. The uncertainty is a product of future federal and state tax rates and the future rate of income, which are all unknown circumstances until you retire. Therefore, the pre-tax contribution strategy is most suitable for individuals who expect to be in either the same or lower tax bracket in the year they choose to use their retirement funds.

Benefits associated with pre-tax contributions include automatic bi-weekly or semi-monthly contributions and a smaller tax liability in current year contributions.

What are Roth Contributions?

Roth—also known as post-tax—contributions are made with after-tax money. Individuals are taxed at the time they make their bi-weekly or semi-monthly contribution, and therefore qualified distributions are tax-free. With these contributions, many enjoy the benefit of withdrawing qualified distributions without tax adjustments. This contribution method is best suited for those who expect to be in a higher tax bracket at the time of withdrawal.

Benefits of 401(k)s

There are more perks that come from individual retirement accounts than just tax advantages.

Compound Interest: 401(k)s take advantage of compound interest/investing, meaning your investment earnings generate their own earnings over time. The earlier you start contributing to a company 401(k), the more you can benefit from the power of compounding, potentially growing your retirement savings substantially.

Investment Flexibility: 401(k)s offer a range of mutual fund investments with varying asset allocations depending on your employer’s plan. This flexibility allows you to tailor your investment strategy to match your risk tolerance, time horizon, and retirement goals.

Financial Security: By consistently contributing to a 401(k)-contribution plan, you are building safety net that can provide financial security during your retirement years. Knowing you have a dedicated account for retirement savings can give you peace of mind and help you plan for a comfortable future.

401(k) plans are a powerful tool for building your financial future and a comfortable retirement. By understanding available options and their benefits, you can make informed decisions that align with your retirement goals.

How can Marsh McLennan Agency Help?

For more information on 401(k) plans and to gain a deeper understanding of your retirement options, don't hesitate to reach out to your MMA Prosper Wise℠ Team. Our knowledgeable advisors can provide personalized guidance tailored to your financial goals, helping you navigate the complexities of retirement planning, and identify the most suitable strategies for securing your future. MMA Prosper WiseSM provides tools, education, and personalized coaching to help you prepare for and manage your retirement plans. Learn more about our retirement tools and resources.

Securities and investment advisory services offered through MMA Securities LLC (MMA Securities), member FINRA / SIPC, and a federally registered investment advisor. Main Office: 1166 Avenue of the Americas, New York, NY 10036. Phone: (212) 345-5000. Variable insurance products distributed by MMA Securities LLC, CA OK 81142. Marsh & McLennan Insurance Agency LLC and MMA Securities LLC are affiliates owned by Marsh & McLennan Companies. Investment advisory services for MMA Prosper WiseSM are offered solely as a Registered Investment Adviser through MMA Securities. Certain of our investment adviser representatives are registered representatives of MMA Securities. A copy of our written disclosure statement discussing our advisory services and fees is available for your review upon request. Please consult a tax professional for specific tax inquiries and recommendations. MMARetirement.com
 

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