The pros and cons of pretax vs. after-tax Roth contributions

Welcome to Ask an Adviser, EBN’s weekly column in which benefit brokers and advisers answer (anonymous) queries sent in by our readers. Looking for some expert advice? Please submit questions to askanadviser@arizent.com. This week, we asked Ted Benna —whose “Father of the 401(k)” title dates back to when he created and gained IRS approval of the first 401(k) savings plan — to weigh in on the following:What are the pros and cons of pretax vs. after-tax Roth contributions?

Pretax savings enables someone to grow their retirement savings 15-50% faster than after-tax savings. Growing savings more rapidly is probably more important than what tax rates will be 20 or 30 years from now. A larger nest egg is a big plus if an event happens when someone is in their 50s, requiring them to dip into savings earlier than expected. That event could be a lost job, divorce, disability — or pandemic. This is true whether the savings involve employer-based plans such as a 401(k) or individual IRAs.

After-tax Roth contributions first became available during 1997. Savers have been asked ever since then whether they expect tax rates to increase or decrease. The expectation has been that tax rates will increase. However, tax rates are lower now than they were in 1997.  Most retirees also have substantially less taxable income when they retire than when they are working. For example, someone who earned $75,000 during 2021 and retired on December 31, 2021 is unlikely to have as high a taxable income during 2022 as during 2021.  

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Contributing the amount needed to get the maximum employer matching contribution is another reason to consider pretax contributions. It is easier to contribute the amount needed to get the full match because the tax savings results in a smaller reduction in an employee’s paycheck. 

Solo entrepreneurs and family-run businesses also can establish a plan that will enable them to avoid paying the 15.3% FICA (Social Security) taxes on their retirement contributions. Avoiding the FICA tax is a permanent rather than deferred tax savings. A solo entrepreneur who is in a 22% federal tax bracket, plus a combined 10% state and city or local tax rate, can achieve a 47.3% advantage when the 15.3% FICA taxes are included. (22+10+15.3). 

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Political risk is another factor to consider. The taxation of Social Security benefits is a clear example. As much as 85% of an employee’s Social Security benefits can be taxed even though they pay federal income tax on the amount contributed to Social Security. 

Having said this, there are several reasons why we need to be concerned about the Roth contribution push at both the federal and state level. A growing number of states are requiring employers that do not have a retirement plan to set up one. They offer plans that make it easy for small employers to set up a payroll deduction IRA. In most instances, the contributions are invested in Roth IRAs because this avoids lost tax revenue that would result if employees made pretax contributions. Small employers have better options.

Read more: Preparing for the SECURE Act’s impact on 401(k) eligibility

The Secure Act 2.0, which recently passed the House, contains some good provisions. However, it also requires that all catch-up contributions must be Roth contributions. In addition, employees will be permitted to receive employer matching contributions as Roth contributions.

The result will be huge administrative burdens that raise employer and employee taxes if this option requires that the Roth matching contributions will be additional compensation subject to federal, state, and local income/wage taxes, FICA, unemployment and workers’ compensation. These changes are backdoor efforts to raise additional tax revenue rather than ways to help employees. This is the only reason these changes were included in the Secure Act 2.0 passed by the House. Hopefully the Senate will drop these provisions.