Pre-tax or Roth?

Tax arbitrage leads the way.

Knowing where to invest is usually one of the biggest questions when people begin saving. There are a ton of options… 401(k)s, HSA, Roth IRAs, Traditional IRAs, and brokerage accounts usually come to mind.

Rather than compare the account types, let’s take a look at the type of contributions. For simplicity, we’ll be comparing Roth dollars contributed to a 401(k) and pre-tax dollars contributed to a 401(k).

Roth dollars are contributed after-tax, grow tax-free, and are distributed completely tax-free after the age of 59.5.

Pre-tax dollars are contributed before tax, grow tax-free, and are taxed as ordinary income when distributed after age 59.5

Tons of people find themselves in a predicament when deciding which types of dollars to contribute to their 401(k) or retirement plan.

I wish there were some blanket recommendations when it comes to this stuff. Unfortunately, there are none that I think are worthy of being mentioned!

Before we get too into the weeds, I want to say that this is a niche aspect of optimization. For most, contributing anything to a retirement account is a very good thing.

The argument for the Roth:

Roth dollars are incredibly powerful. Tax-free distributions are something that almost everyone can get behind.

I have seen some pose Roth contributions as “Tax the seed, not the harvest.” This is a solid saying, although a bit basic.

Roth dollars are pretty special for those who have not reached their peak earnings years. Essentially, for people who don’t earn much just yet, they also don’t pay much in tax. When people pay less in taxes or are in the 10%, 12%, or 22% bracket, paying the tax today may not be so bad!

For those who may have an off year for earnings and drop a tax bracket or two, the Roth contributions can be very enticing.

At the end of the day, Roth dollars offer one thing that I think a lot of other account types cannot: certainty.

People love certainty. Contributing Roth dollars today allows them to know that they will not be taxed on those distributions during retirement.

It also allows people to have a better understanding of what is actually available to them for retirement.

$1,000,000 in a pre-tax 401(k) and $1,000,000 in a Roth 401(k) are two veryyyy different things.

The argument for pre-tax:

While tax-free distributions are pretty sweet, pre-tax contributions can also be a very attractive avenue to saving.

For those who find themselves in the 32%, 35%, or 37% tax brackets, any deduction from income can be huge.

Take someone in NY for example. In the 37% bracket, they are likely also paying an additional 6.85% before any local taxes.

In the event they were to contribute $23,500 (the 2025 maximum), they would likely save over $10,000 in taxes for the contribution.

The simplest way to win the pre-tax contribution game is by way of tax arbitrage. Essentially, contributing when taxes are higher than the rate at which they are withdrawn is how to “win”.

If someone can contribute pre-tax dollars in the 37% bracket and distribute funds in the 12%, 22%, or 24% bracket, they have successfully executed on tax arbitrage.

At the end of the day, investing any amount, either pre-tax or Roth, is awesome. For some, they want to further optimize their financial standing, and the optionality offered by some 401(k) plans can allow for that.

BONUS Content:

Depending on where someone lives, if they work in a high state tax state and plan to move to a state levying lower state or no state taxes, the pre-tax contributions have the potential to offer even more tax arbitrage.

This is for informational purposes only and is not intended as legal or investment advice or a recommendation of any particular security or strategy. The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation. Opinions expressed in this commentary reflect subjective judgments of the author based on conditions at the time of publication and are subject to change without notice. Past performance is not indicative of future results.