What it means
Many workplace plans began life offering only pre-tax savings. Over time, plan sponsors added a Roth choice so staff could split their saving between the two tax treatments.
The Roth option is simply that choice, available inside a 401(k), 403(b) or similar plan. The employee selects the option through the plan's online portal or an enrolment form, and payroll then deducts the contributions from post-tax pay.
The plan keeps the Roth money in a separate account, because it is taxed differently from the pre-tax balance. Gains on both accounts grow without tax while they stay in the plan.
Choosing between the options depends mostly on tax rates. Someone expecting a higher marginal tax rate (the rate on their next dollar of income) in retirement will tend to favour the Roth option, while someone expecting a lower rate will tend to favour pre-tax.
Because nobody can predict future rates exactly, many people split their savings to spread the risk. An important comparison is how much each choice costs in take-home pay.
A pre-tax contribution reduces tax immediately, so $5,000 saved pre-tax costs less in take-home pay than $5,000 saved to a Roth. To compare like with like, you can ask how much pre-tax saving would give the same take-home cost as a Roth contribution.
For employers, adding the Roth option means extra administration and communication. Payroll systems must separate the two types, and the plan documents have to be amended.
Employers also have to explain the trade-off clearly, since the wrong choice can cost a worker thousands of dollars over a career. The option has rules attached to withdrawals, just like other retirement accounts.
The tax authority sets conditions for what counts as a qualified withdrawal, usually involving a minimum holding period and a minimum age. Taking money out before the conditions are met can lead to tax and penalties on the earnings.
In practice
Real-world examples.
Example
A graphic design agency adds a Roth option to its retirement plan. Employees can tick a box in the benefits portal to send part of each paycheque to the Roth account. The payroll manager sets up separate deduction codes for each type.
Example
A teacher in a public school plan has a low income this year because she worked part-time. She chooses the Roth option because her tax rate is lower than it is likely to be later. She plans to switch to pre-tax when her salary rises.
Example
A hospital administrator, five years from retirement, uses the Roth option for half of his contributions. He wants a pool of tax-free money to manage his taxable income in retirement. The other half goes in pre-tax to reduce his current tax bill.
Formula
Calculation
Pre-tax equivalent of a Roth contribution = Roth contribution / (1 - current marginal tax rate)
Suppose an employee wants to save with a take-home cost of $5,000, and her marginal tax rate now is 20%. A Roth contribution is $5,000. The pre-tax equivalent is 5,000 / (1 - 0.20) = 5,000 / 0.80 = $6,250. If the money grows by a multiple of 4, the Roth becomes 5,000 x 4 = $20,000 tax-free. The pre-tax account becomes 6,250 x 4 = $25,000, and with a 30% tax rate in retirement, it is worth 25,000 x 0.70 = $17,500 after tax. The Roth option wins by $2,500 in this case.Case study
Seen in the real world.
Cedar Ridge Logistics is an illustrative, fictional employer that wanted to improve its retirement plan. Its human resources lead added a Roth option and built a simple calculator for staff.
The calculator showed that a worker in a 20% bracket who put in $5,000 after tax would, with a growth multiple of 4, reach $20,000 tax-free. A pre-tax contribution of $6,250 would reach $25,000, but at a 30% retirement rate would be worth only $17,500 after tax.
After reading the examples, about a third of younger staff chose some Roth saving, while older workers mostly stayed with pre-tax. The illustrative lesson is that a clear worked example helps people choose the option that fits their stage of life.
Watch out
Common mistakes.
- Choosing the Roth option without checking whether the employer actually offers it in the plan.
- Comparing a $5,000 Roth contribution with a $5,000 pre-tax contribution as if they cost the same in take-home pay.
- Forgetting that early withdrawals of earnings can attract tax and penalties.
Questions
People also ask.
Can I split my contributions between Roth and pre-tax?
In most plans yes, and many people do so to spread their tax risk.
Does the Roth option change the investments I can choose?
Usually no, because the investment menu is the same, and only the tax treatment of the money differs.
Is the Roth option always the better choice for younger workers?
Not always, but it is often attractive because they have a long time for tax-free growth and may earn more later.
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