Author: David I. Templeton, CFA, Principal and Portfolio Manager

A practical look at the pros and cons of pre-tax and after-tax retirement savings strategies, and how Roth conversions may help reduce future tax burdens.

I recently ran across commentary around a question presented to wealth advisors and financial planners regarding where one should focus their savings dollars, i.e., in a pre-tax or post-tax account. What was apparent is there is not a clear answer to the question of what type of account to focus on in saving for retirement; however, there are pros and cons to each type of investment arrangement.

Understanding Pre-Tax vs. After-Tax Savings  

Pre-tax accounts are those where the funds contributed to the account are deducted from one's taxable income thus reducing the amount of taxes paid in the applicable year of the contribution. Examples of pre-tax accounts are a 401(k), 403(b) 457 plan, and Health Savings Account (HSA) to name just a few. After tax accounts consist of savings where the funds used for the contributions have already been taxed like contributions to a brokerage account, Roth IRA or Roth 401(k). In other words the contributions to after tax accounts are not tax deductible.

An issue with having most of one's retirement savings in pre-tax accounts, a retiree may end up in a higher tax bracket in retirement as larger required minimum distributions are made from the pre-tax accounts. This has become an issue for some retirees as the minimum distribution age continues to be raised. Beginning in 2023 the RMD age was increased to 73 and beginning in 2033 the RMD age increases to 75. 

Matching Contributions: An Often Overlooked Source of Return

To help guide an investor into which type of account to begin saving in, an important question to answer is whether an employer retirement account, 401(k), 403(b), has a matching contribution. If there is a matching contribution, one should invest in the employer account up to a sufficient amount to receive the full employer match. For example, some employers will match an employee's contribution at 50 cents on every dollar saved up to 4% of an employee's contribution. In this case, the employee is earning a return of 50% on the 4% just from the match.

Heath Savings Accounts: The Triple Tax Advantage

If one has a high-deductible health insurance account, they should contribute the maximum amount allowable to the HSA or Health Savings Account. The HSA contribution limits for 2025 are $4,300 for individual coverage and $8,550 for family coverage. Those 55 and older can contribute an additional $1,000 as a catch-up contribution. The HSA contribution limits for 2026 are $4,400 for individual coverage and $8,750 for family coverage. HSA's are unique in the funds are essentially triple tax free, i.e., the funds contributed are made on a pre-tax basis, the growth compounds tax free and withdrawals are not taxed if used for qualified medical expenses.

Roth Conversions: A Strategic Tool for Tax-Efficient Retirement

For those nearing retirement and find themselves in a position where a large portion of their savings is in pre-tax retirement accounts there are strategies one can consider pursuing to potentially lower the tax impact on future retirement withdrawals. An imbalance in pre-tax investments and post-tax investments is not uncommon as one's higher earning years come later in their career. One strategy for individuals to evaluate is what is known as a Roth conversion. A Roth conversion is where one moves investment funds from a pre-tax retirement account to a post-tax Roth account. The amount that is moved is taxed as ordinary income. For this strategy to be most advantageous, the individual would pay the tax on the Roth conversion with post-tax funds. If one works with a wealth advisor or financial planner a projection can be prepared to estimate what amount of conversion should be considered with the goal of the conversion to limit the amount of income to the top of say the 22% and maybe 24% federal income tax bracket with the goal of paying tax now in a lower tax bracket versus later in retirement.

From a timing perspective, if one retires at age 65, and let's assume social security is deferred to age 70 to receive the highest possible increase in benefit beyond their full retirement age, Roth conversions could be spread out from age 65 to age 70. Additionally, the conversions are likely to reduce one's RMD's after age 70 thus potentially minimizing the tax on social security benefits too.

Another benefit is the Roth conversion strategy might be an effective wealth transfer strategy. Pre-tax retirement accounts have become less effective wealth transfer vehicles. In most cases, funds in pre-tax retirement accounts need to be withdrawn by a non-spouse beneficiary within ten years of the beneficiary inheriting the IRA. The Secure Act 2.0 eliminated the stretch IRA benefit that was available to a non-spouse beneficiary. As noted in a recent Kiplinger article, "Previously, non-spouse beneficiaries could stretch required minimum distributions (RMDs) over their own lifetimes, allowing them to spread out withdrawals and tax obligations over many years." There is the likelihood that the non-spouse beneficiary may be an older child in their peak earning years and required IRA distributions might occur during the child's high earning period; thus, paying income tax at a higher rate than the original IRA owner might incur during the Roth conversion period. 

Where to Start Saving: Building a Tax-Efficient Portfolio Early

So as one enters the workforce be it as a new physician, lawyer or employee of any company, it is likely one's initial salary will be lower at the beginning of one's career versus later. This potentially puts an individual in a lower tax bracket now versus when they near retirement. Funding pre-tax accounts at a level to receive any matching contribution makes sense. Additionally, funding a Health Savings Account, if an option, makes sense too. Beyond this, focusing retirement savings in after tax Roth accounts would be beneficial if in a lower tax bracket. Having a large portion of one's investments that will generate income for retirement in after tax accounts likely minimizes taxes paid later, while in retirement. Of course, after tax accounts do have taxes associated with them. Taxes are paid on dividend and interest earnings on the accounts as well as paying capital gains taxes generated from investment transactions during a given year. At the moment though, capital gain taxes are at a level lower than the top income tax brackets that may apply to RMD's taken in retirement. As with many things, balance is important, but it is hard to image federal taxes are lower in the future than where they are today so focusing on after tax investment accounts seems like a worthwhile approach today.