For many people, it’s a lifelong dream to find a job that they like that is enough to pay the bills, gives you time off to spend with your family or hobbies, and affords you extra to sock away money for retirement. After many years of savings and savvy investing, you can quit your job and live comfortably or travel the world.

There are a few ways you can save for retirement. You can take some money and put it in a savings account, sock it under the bed, pray that you win the lottery, or invest a little at a time in an established retirement account. Well, the first one is safe with little risk, but investing in a retirement account is the best way to reach your financial goal.

The most basic account is a 401(k) plan sponsored by your employer. Each paycheck, an automatic deduction takes out a percentage of your income (before taxes) and puts it in an investment medium. This is usually a mutual fund (a combination of stocks or bonds). If you are lucky, your employer might also match a portion of your contribution, adding to your account. 

In addition to 401(k)s, there are traditional and Roth IRAs, aka individual retirement accounts.

Over time, your contributions will grow through the magic of compounding. Depending on the risk factors, regular contributions, and the state of the stock/bond market, the money you put in today could grow to a substantial sum in the future.

There are several factors to consider when deciding which type of retirement savings account is right for you, including taxes, contributions, and distributions. Is Roth IRA pre-tax? Let’s dive into the nitty-gritty details of each of these, and then you can decide which one works best for you.

How Roth IRA Taxes Work and When You Pay

401(k) and Traditional IRAs are also called pre-tax contribution plans, which means you can contribute to the plans before income taxes are taken out of your check. This can lower your tax obligation in the current year while enabling you to set aside money for your future. When you reach retirement age and start withdrawing the money, you will then owe taxes on the money as you withdraw it. 

Roth IRAs work a little differently. With a Roth IRA, you pay income taxes on your paycheck and then fund your account with after-tax dollars. When you reach retirement age and decide to withdraw your funds to live on, you can use that money tax-free.

So, the big difference is when the IRS will get its money–and the biggest question to ask yourself is whether it’s more advantageous for you to pay taxes upfront or defer it until you get older. It becomes a tricky situation to predict. The advantage of paying taxes later is that you may have a lower income and fall into a lower tax bracket when you hit retirement age. Of course, you may also have fewer deductions in your older years. Everyone’s situation is unique, so it’s important to talk to a professional when faced with a decision. 

Roth IRAs

Roth IRAs are a more recent option for retirement saving accounts (established in 1998). Like other retirement accounts, you fund your account and let it grow for a set period. But there are some significant differences.

A Roth IRA is funded using post-tax dollars. This means that you get your paycheck or some form of income and have already paid taxes. With these already-taxed dollars, you can fund your Roth IRA account. 

As long as you hold onto the account for at least five years and wait until you are 59 ½, you will be able to withdraw it tax-free. 

If you withdraw the money before the five years have elapsed, and before you are 59 ½, you are subject to an early withdrawal penalty, unless you use the money for a first-time home purchase, qualified education expense, medical costs, you have a disability or incur financial hardship.

You are not required to withdraw money at any age. If you do not withdraw the money and the fund is passed on to your heirs, they will not need to pay taxes as long as they withdraw it after they turn 59 1/2.

There are restrictions on who can contribute to a Roth IRA. For 2022, if you are single and open a Roth IRA, you must make less than $144,000. Married couples must make less than $214,000 combined income.

There are restrictions on how much you can contribute per year as well. If you are below 50 years old, the maximum amount you can contribute to a Roth IRA is $6,000 per year. If you are over 50, you can contribute an extra $1000 per year.

Traditional IRAs

Traditional IRAs defer your tax payments until after you retire, and the money you set aside when you actively contribute to the account reduces your taxable income right now. When you start to withdraw your funds in retirement, those are taxed as income. 

You face penalties if you do not wait until age 59 ½ to withdraw your money. There are exceptions to this rule–for example, you can withdraw money early to buy your first house, pay for higher education, or collect disability. Even if you avoid the penalty during early withdrawal, you will still have to pay taxes.

Once you turn 70 ½, you must start to withdraw your funds.

Key Differences

Let’s summarize the differences between the two plans.

  Traditional IRA Roth IRA
Taxes Funded with pre-tax dollars, so taxes are assessed upon withdrawal Funded with taxed dollars, so the funds are available tax-free upon withdrawal
Income Limits Anyone can open and contribute to a Roth IRA, regardless of their income Only those who do not exceed the modified adjusted gross income levels can open and contribute to a Roth IRA. Check with the IRS, as these limits vary from year to year.
Contribution Limits In 2022, an individual can contribute up to $20,500 (if you are below 50) and $27,000 (if over 50), and that amount is a combined limit that can be split among traditional and Roth IRAs. In 2022, the maximum amount you can contribute is $6000, and if you are over 50, you can add an additional $1000 per year
Withdrawals Withdrawals must start no later than age 70 ½ unless you are still working and do not own more than 5% of the company you are working for. Withdrawals are not taxed after age 59 ½ as long as the account is at least five years old

 

Is Roth IRA Pre-Tax: What’s the Difference Between a Roth IRA and a Pre-Tax Contribution Plan?

There are some key differences between pre-tax contribution plans and Roth IRAs. 

Contributions

First, there is a limit on the amount of money you can earn to qualify to open a Roth IRA. In 2022, your income needs to be less than $214,000 if you are filing as a married couple and less than $144,000 if you are filing taxes as a single person. There are no income limitations on a pre-tax contribution plan.

There are limits on the amount of money you can set aside in each plan. You can set aside $6,000 per year in your Roth IRA if you are under the age of 50. Once you reach 50, you can contribute an extra $1,000 per year. With pre-tax contributions, the limit is much higher—$22,500 in 2023. 

A pre-tax contribution plan is precisely what it says. The plan is funded through the money you earn before income taxes are withheld. 

Distributions

For either plan, once you reach age 59 ½, you can start withdrawing your money, but you don’t have to. 

Pre-tax contribution plans require that you start taking distributions at age 70 ½, which are 100% taxable. 

With a Roth IRA, you can take distributions starting at age 59 ½, but it is not required. In fact, you do not ever have to touch the money and can even leave it to your heirs. 

You need to leave your money in a Roth IRA for at least five years before taking it out, or you face penalties.

Plan Ownership

A Roth IRA and a traditional IRA (funded with pre-tax contributions) are individually owned, meaning that you are in charge of where the fund is set up and its investment strategy.

Other pre-tax contribution plans, such as a 401(k) sponsored by your employer, are set up and managed by the company. They choose the firm that manages the funds, and your investment options are limited. You can, however, generally contribute more. 

How to Decide: Pre-Tax Vs. Roth

Deciding between retirement plans can be tricky, and it comes down to availability and income. If you work for an employer who matches contributions, you’ll want to take advantage of this benefit–it’s extra money in your pocket. 

After that, look at your income. Pre-tax contribution plans lower your adjusted gross income, possibly lowering your tax bracket in the current year. While you are taxed when you retire and start collecting money from the funds, your gross income is likely lower. This all depends on how much you put into the fund and how much it grew over time.

The good news is that you don’t need to choose between one or the other.

Can I Contribute to Both?

Yes, you can contribute to a pre-tax plan and a Roth IRA if you do not exceed the income limits set by Roth IRA rules. There are also contribution limits if you contribute to both a traditional IRA and a Roth IRA. Each plan has its advantages; if you didn’t start investing when you were very young, you can use this strategy to catch up. 

What if I Leave My Job?

A Roth IRA plan is not tied to your job, so it’s yours alone, no matter who you decide to work for. In fact, many self-employed individuals contribute to a Roth IRA for their retirement plan.

If you have a 401(k) and your employer matches a portion of the contribution, they may restrict the amount of money they put in. For example, they might require you to stay at your job for a certain period of time before you can keep the funds they set aside in the account.

Generally, when you leave your job, all money that you put into either fund is yours. You’ll need to roll the balances from your employer’s plan to an IRA you will now manage.

The Takeaway

We’ve talked a lot about contributions and distributions, but we’d be remiss if we did not discuss the risks associated with any investment account.

Saving for retirement is not without risk. Many people treat it like a savings account and assume that the funds will grow, and the money will be there when needed. There is a good chance that this will be the case, but it’s important to invest wisely and pay attention to your investments.

Most retirement accounts invest in stocks and bonds, and there is a good reason for this. Over the long run, these investments tend to grow–but not always. Individual companies can have good years and bad years, and even go bankrupt. A mutual fund alleviates this risk by investing in various stocks and bonds–so if one suffers a setback, it will not adversely affect the entire portfolio. 

Investing for your retirement can be confusing, but you can’t take advantage of the benefits unless you start investing. You’ll want to get started as soon as possible to take advantage of compounding interest rates and the ups and downs of the market. Set up an account and start putting regular contributions into the funds. Study the investment options and decide how much risk you are willing to take. Once the account is set up, please do your best not to touch it. Using your retirement account as an emergency fund is not a good plan. 

The good news is that you don’t have to go it alone. Before you sign up for a 401(k) plan or set up a traditional or Roth IRA, do some homework. Take a look around this website for valuable financial tools and articles. 

Please think of me as your personal financial advisor. Then book a call with The Budgetnista. Together, we can put your mind at ease.

About the Author Tiffany Aliche

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