Pre-tax, Roth or Both? Help Grow Your Net Worth With These 401(k) Hacks for High Earners - Senior Executive
Financial Planning for Executives 6 min

Pre-tax, Roth or Both? Help Grow Your Net Worth With These 401(k) Hacks for High Earners

Let’s look at a few ways you can maximize your 401(k) with this brief tutorial on which contributions to make—standard pre-tax 401(k), Roth 401(k) or both.

by Michael Aloi on July 29, 2022

Executives typically have several different ways to save for retirement: deferred compensation, company stock, pensions and, of course, the good old-fashioned 401(k), to name a few. However, in my experience, executives don’t have the time to maximize their 401(k) plans—they’re too busy running companies and have more pressing decisions to make—but this can be a mistake as certain 401(k) contributions could help you save on taxes in retirement. Let’s look at a few ways you can maximize your 401(k) with this brief tutorial on which contributions to make—standard pre-tax 401(k), Roth 401(k) or both.

The Basics of 401(k) Contributions

If you’re unfamiliar with 401(k) contributions and how they work, here’s a quick breakdown:

  • The maximum contribution to a 401(k) in 2022 is $20,500, unless you are 50 or older, in which case you can contribute an additional $6,500 in “catch-up contributions.” 
  • Many employers will match contributions up to a certain percentage, and while you may have a choice between making pre-tax or Roth contributions, depending on your plan, employer contributions are always made into the pre-tax account. 
  • Pre-tax contributions to your standard 401(k) reduce your taxable income today, which should help you save a few bucks on your tax return. However, withdrawals in retirement from pre-tax accounts will be taxed then. Let’s say you take $100,000 out of your pre-tax 401(k) in your first year of retirement. That’s $100,000 of taxable income that will be treated as such come April 15.
  • A Roth 401(k) is the opposite: No tax deduction today on your contributions, but qualified withdrawals in retirement will be tax-free. In this case, “qualified” means you are over 59 ½ and have had the Roth account open for at least five years. 

So, which is better, standard 401(k) or Roth 401(k)?

Pre-Tax 401(k) vs. Roth 401(k) Contributions

Is a Roth 401(k) right for you? It depends on your future tax rate. If you expect your future retirement tax rate to be the same, it makes no difference from a tax perspective in the long run whether you fund a Roth 401(k) or regular 401(k). If, like many high earners, you expect to be in a lower tax bracket in retirement, then a regular 401(k) contribution today makes sense for you. However, if you expect to be in a higher tax bracket in retirement, then the Roth 401(k) should pay off in the long run since that withdrawal will be tax-free. The problem, of course, is most people don’t know which tax bracket they will be in during retirement. For this reason, I generally recommend a hybrid 401(k) approach to my clients.

The Hybrid Approach to 401(k) Contributions

If your 401(k) allows for it, you may be able to make both Roth 401(k) and regular 401(k) contributions – say, 50% into the standard pre-tax 401(k) account and the other 50% into the Roth 401(k). (Note: Not all 401(k) plans allow for a Roth contribution, so check with your plan provider.)

The hybrid approach is a hedge: If tax rates jump up once you reach retirement, you’ll be grateful you made some Roth 401(k) contributions now. If you find you’re in a lower tax bracket in retirement, then you’ll be glad you contributed to the standard 401(k). In practice, I find clients usually put a higher amount into the pre-tax bucket to save on taxes today. Usually, 75%-80% of their contributions go into the standard pre-tax 401(k) account, and the remaining balance goes into the Roth.

The Exception: Income Diversification

Of course, every rule has an exception. For those nearing retirement who may have made exclusively pre-tax 401(k) contributions throughout their career, switching future contributions entirely to the Roth 401(k) can make sense. This is called income diversification. Diversifying your future income can prevent what we advisors call “bracket creep,” or getting bounced into the next (and higher) tax bracket.

Here’s how it works. Let’s compare taking $100,000 out of a pre-tax 401(k) in retirement versus withdrawing a mix of $100,000 from a standard pre-tax 401(k) and your Roth 401(k). If you withdraw $100,000 from your pre-tax 401(k), your estimated federal tax on that income would be $13,234 (ignoring deductions and credits for simplicity’s sake). If instead, you withdraw $83,550 from the standard pre-tax 401(k) account and the balance—$16,450— from the Roth 401(k), then your $100,000 in income includes only $83,550 in taxable income to land you in the 12% tax bracket. You would pay no tax at all on the $16,450 from the Roth 401(k) – and lower the tax rate on the remainder of your income! All else being equal, the savings is about $3,619 in federal taxes.

Married Filing Jointly Taxable IncomeBase Amount of TaxPlusFederal Tax RateAmount Over
$20,551 to $83,550$2,055+12%$20,550
$83,551 to $178,150$9,615+22%$83,550
Table 1: 2022 Income Tax Brackets (selected)
Source of WithdrawalsBase Amount of Tax
Plus Tax on Marginal Amount
Total Federal Tax
$100,000 from standard pre-tax 401(k)$9,615$3,619$13,234
$83,550 from standard pre-tax 401(k) and $16,450 from Roth 401(k)$2,055$7,560$9,615
Table 2: Taxes on Withdrawals From 401(k) and Roth 401(k) Accounts

Required Minimum Distributions

Unless you’re still working, all 401(k), Roth 401(k) and regular IRAs require you to start withdrawing money at age 72, even if you don’t need it. For high earners who have maximized their 401(k) over the years, a required minimum distribution (RMD) from these accounts can mean substantial taxable income that, added to other taxable income, can push you into the highest tax brackets. Pro tip: There are currently no RMD from a Roth IRA. Once you leave your employer, roll your Roth 401(k) into a Roth IRA, and never face a required minimum withdrawal on that money.

The Mega-Back-Door Roth IRA

One last uber-valuable tip for high earners: The annual maximum 401(k) contributions – in 2022, $20,500 plus $6,500 more for those 50 and older – that you hear about refer to pre-tax and Roth contributions. But your 401(k) plan may allow you to contribute additional after-tax contributions as well, and you should take advantage with Roth IRA benefits in retirement in mind.  The earnings on those after-tax contributions to your standard 401(k) will be taxable upon withdrawal in retirement. However, after leaving the company, you can roll over those after-tax 401(k) contributions—not the earnings, only the contributions—to a Roth IRA tax-free. This is another way to increase your Roth account. This is called a “mega-back door” Roth IRA and is a great way for high-income executives to sock away more in the Roth.

Disclaimer: Investment advisory and financial planning services are offered through Summit Financial LLC, an SEC Registered Investment Adviser, 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600 Fax. 973-285-3666. This material is for your information and guidance and is not intended as legal or tax advice. Clients should make all decisions regarding the tax and legal implications of their investments and plans after consulting with their independent tax or legal advisers. Individual investor portfolios must be constructed based on the individual’s financial resources, investment goals, risk tolerance, investment time horizon, tax situation and other relevant factors. Past performance is not a guarantee of future results. The views and opinions expressed in this article are solely those of the author and should not be attributed to Summit Financial LLC. Summit is not responsible for hyperlinks and any external referenced information found in this article.

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