Choosing Between Pretax and Roth 401(k) Contributions: Beyond the Basics
When planning for retirement, individuals often face the choice of contributing to a traditional 401(k) with pretax dollars or a Roth 401(k) with after-tax funds. While the traditional option offers immediate tax relief, withdrawals are taxed as ordinary income. Conversely, Roth contributions are taxed upfront, but withdrawals grow and are taken tax-free. However, this decision is more nuanced than simply comparing current and future tax brackets.
Marginal vs. Effective Tax Rates: Understanding the Difference
Tax planning often hinges on marginal tax rates—the percentage applied to the last dollar earned within a progressive tax system. Yet, certified financial planner Cody Garrett emphasizes that effective tax rates—the total tax paid as a percentage of gross income—offer a more realistic measure for retirement planning decisions.
“People always talk in marginal rates, but lived experiences are [your] effective rates,” said Garrett, founder of Measure Twice Planners and co-author of Tax Planning To and Through Early Retirement.
Unlike marginal rates, which apply to income tiers, effective rates reflect the actual tax burden across all income. This distinction can significantly impact whether traditional or Roth contributions are more advantageous.
Example: Calculating Marginal and Effective Tax Rates
Consider a 50-year-old single filer earning $200,000 in 2025, with a standard deduction of $15,750. The taxable income is $184,250. Taxation across brackets breaks down as follows:
- $11,925 taxed at 10% = $1,192.50
- $36,550 taxed at 12% = $4,386
- $54,875 taxed at 22% = $12,072.50
- $80,900 taxed at 24% = $19,416
Total federal tax liability sums to $37,067. While the marginal tax rate is 24%, the effective tax rate is approximately 18.5% ($37,067 divided by $200,000). In fact, gross income must exceed $326,900 for the effective tax rate to reach 24%. This example illustrates that relying solely on marginal rates can misrepresent the actual tax impact of retirement contributions.
Adopting a Lifetime Tax Perspective for Retirement Contributions
Financial experts recommend evaluating contribution strategies over the long term. CPA Jeff Levine advises that the ultimate objective is to pay taxes when rates are lowest, which may not align with current marginal tax brackets.
“Your goal is to pay tax when the rate is the lowest,” said Levine, underscoring the importance of multiyear tax planning.
Moreover, having pretax savings can create future flexibility, such as enabling Roth IRA conversions during early retirement, which can optimize tax efficiency.
FinOracleAI — Market View
The decision between pretax and Roth 401(k) contributions is a pivotal element of retirement tax strategy. Emphasizing effective tax rates over marginal rates offers a more accurate framework for optimizing tax outcomes across one’s lifetime.
- Opportunities: Tailoring contributions to expected effective tax rates can enhance after-tax retirement income.
- Risks: Misjudging future effective tax rates may lead to higher-than-expected tax liabilities in retirement.
- Flexibility: Maintaining a mix of pretax and Roth savings allows strategic tax planning, including conversions.
- Complexity: Requires careful, personalized tax analysis rather than simplistic bracket comparisons.
Impact: This refined approach to retirement contributions encourages more informed tax planning, potentially improving retirement financial security and reducing unexpected tax burdens.
