Searching for retirement planning but getting stuck between an employee deferral vs. a Roth deferral? Both are ways to set aside money for future use, but they have distinct characteristics and tax implications. So, how do you know which one to prioritize—or if you should use both?
Let’s break down these concepts so you can confidently navigate your retirement savings.
Understanding employee deferral vs Roth deferral
What are these options in the first place? What is a Roth contribution? What does a deferral mean? We'll start with the basic definitions so you can make an informed decision.
What is employee deferral?
An employee deferral is a voluntary decision to reduce your current taxable income by contributing a portion of your paycheck to a retirement account, such as a 401(k) or 457 plan (a plan offered to government employees and those who work for nonprofit organizations). The amount you defer is not subject to income tax in the current year. You’re essentially setting aside pre-tax dollars, reducing your taxable income today. “However, these contributions will be taxed when withdrawn in retirement,” says Dana Ronald, enrolled agent (EA) and founder of Tax Crisis Institute.
For example, if your salary is $50,000 and you contribute 10%, or $5,000, to your 401(k), you’ll only be taxed on $45,000 this year. However, when you start withdrawing funds after age 59½, you’ll pay taxes on your contributions and any investment growth.
Key points about employee deferrals:
- Pre-tax contributions: Your contributions are made with pre-tax dollars, reducing your taxable income.
- Tax-deferred growth: Your investments grow tax-deferred within the account.
- Tax liability at withdrawal: When you withdraw funds in retirement, you'll pay income tax on the distributions.
What is a Roth deferral?
A Roth deferral, such as a Roth 401(k) or Roth IRA contribution, works differently. Contributions are made with after-tax dollars, so you don’t get an immediate tax break. The benefit is that your earnings and qualified withdrawals are tax-free in retirement.
“While you won’t get an immediate tax break, earnings and withdrawals being tax-free in retirement are ideal if you expect to be in a higher tax bracket later or want tax-free growth,” Ronald says.
Key points about Roth IRA deferrals:
- After-tax contributions: You contribute with after-tax dollars.
- Tax-free growth and withdrawals: Your contributions and investment earnings grow tax-free, and qualified withdrawals in retirement are tax-free.
- Income limits: Eligibility for Roth IRA contributions is subject to income limits.
Employee deferral vs Roth deferral: Taxes now and later
Taxes are the main factor distinguishing employee deferral vs Roth deferral strategies. Here’s a breakdown:
- Employee deferral (traditional 401(k)): Taxes are deferred until withdrawal, which is beneficial if you expect to be in a lower tax bracket during retirement.
- Roth deferral (Roth IRA/401(k)): Taxes are paid upfront, allowing you to enjoy tax-free withdrawals later. This is advantageous if you expect to be in a higher tax bracket in retirement or want to avoid paying taxes on investment growth.
Which one is right for you?
To make the right decision, consider your current and future tax brackets. In other words: Will your income be higher in retirement than it is right now?
“If you anticipate being in a higher tax bracket during retirement, Roth IRA deferral may be a better option,” Ronald says.
The best choice between an employee deferral and a Roth IRA deferral depends on your individual financial situation, tax bracket, and long-term goals. Consider the following factors to make your decision:
- Current tax bracket: If you're in a higher tax bracket now, an employee deferral can provide immediate tax savings.
- Future tax expectations: If you anticipate being in a higher tax bracket in retirement, a Roth IRA can offer tax-free withdrawals.
- Risk tolerance: Both options allow for various investment strategies, so consider your risk tolerance and investment goals.
- Income limits: Be aware of the income limits for Roth IRA contributions. In 2024, the employee deferral limit for 401(k) plans is $23,000 for individuals under 50, with an additional $7,500 for those 50 and older.
Other considerations
There are other benefits and considerations of both employee deferrals and Roth deferrals. Here’s what to know.
- Long-term growth: Both options allow your money to grow tax-advantaged, helping you build wealth for retirement.
- Employer matching contributions: Many employers offer matching contributions for both traditional and Roth 401(k) plans. This is essentially free money for retirement, so it's important to take advantage of it if your employer offers it.
- Immediate vs delayed tax breaks: With Roth deferrals, there’s no immediate tax benefit, which can be a downside if your budget is tight.
- Contribution limits: Both employee and Roth deferrals have annual limits. In 2024, the employee deferral limit for 401(k) plans is $23,000 for individuals under 50, with an additional $7,500 for those 50 and older.
Next steps in retirement investing
Now that you understand the basics of employee deferrals and Roth IRAs, it's time to take action.
- Consult a financial advisor. A qualified advisor can provide personalized advice based on your unique circumstances.
- Review your employer's retirement plan. Take advantage of any employer-matching contributions offered to boost your savings.
- Start early and contribute regularly. The earlier you start saving, the more time your investments have to grow.
- Reevaluate your strategy regularly. As your financial situation and goals change, revisit your retirement plan to ensure it's still on track.
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