When it comes to retirement savings, withdrawals are often an afterthought after putting all the money you earned during your working life into pre-tax savings buckets, such as 401(k)s, IRAs, Roth 401(k)s, and the like. Most professionals have embedded it in our brains to defer, defer, defer as much as possible and not think about the long-term effects of having large amounts of pre-tax money put into our accounts for us to withdraw from during retirement.

I see it all too often with our retiring clients today: the emotional effects of paying taxes after deferring their whole working lives. When retiring, our clients say they wish they had contributed to a Roth 401(k) over a Pre-tax 401(k) once they learn the pros and cons. 

In Alaska, using a Roth 401(k) over a pre-tax 401(k) can be particularly beneficial if you plan to live in Alaska, a state without income taxes during your working years, and retire in a state with income taxes. Here’s how this strategy works:

1. Tax Treatment of Contributions:

• Pre-tax 401(k): Contributions are made before taxes, reducing your taxable income in the contribution year. However, the contributions and the earnings are taxed as ordinary income when you withdraw in retirement.
• Roth 401(k): Contributions are made after taxes, meaning you pay taxes on the income now. However, the earnings and withdrawals in retirement are tax-free (as long as certain conditions are met).

2. State Income Tax Implications:

• While living in a no-income-tax state (during contribution years):
  • Pre-tax 401(k): You save on federal income taxes immediately but don’t get any state tax benefit since there’s no state income tax.
  • Roth 401(k): You still pay federal income taxes on your contributions. However, since there’s no state income tax, you’re not paying any additional tax on the contributions either.
• When you retire in a state with income taxes (during withdrawal years):
  • Pre-tax 401(k): Withdrawals are treated as taxable income at the state and federal level. This means you’ll pay state income taxes on every dollar withdrawn from your pre-tax 401(k), which could significantly reduce your retirement income.
  • Roth 401(k): Withdrawals are tax-free. Since you’ve already paid taxes on the contributions (in a no-income-tax state), you won’t owe any state or federal income tax on withdrawals in retirement which means moving to a state with high-income taxes becomes a massive advantage.

3. Key Benefit of Roth 401(k) in This Scenario:

• By contributing to a Roth 401(k) while living in a no-income-tax state, you lock in the benefit of paying no state-income tax on your contributions. Then, when you retire in a state with income taxes, you avoid paying those state taxes on your withdrawals because Roth withdrawals are tax-free.
• In contrast, if you had contributed to a pre-tax 401(k), you would be deferring taxes only to face potentially higher tax rates in retirement, especially if the state you retire in has a high-income tax rate.

Hypothetical Example

After-Tax 401(k)Pre Tax 401(k)Roth Cost for 20 year

Annual Amount	$10,000	$10,000
Compound %	7%	7%
Tax @ 22% Tax Cost / Tax Savings	Cost $2,200	Savings per yr $2,200	$44,000 ($2,200*20 years)
Number of Years	20	20
Final Value	$448,651	$448,651
Taxed @ 22%	Zero tax	$98,703 + plus 4% state
Final Amount	$448,651	$349,947

Of course, the numbers above are just a hypothetical example. The person in this example would have to withdraw all the money in 20 years.  

4. Potential Long-Term Savings:

• Pre-tax 401(k): You may feel like you are saving more today because of the immediate federal tax break. However, if you end up in a high-income-tax state in retirement, a large chunk of your savings could go to taxes later.
• Roth 401(k): Although you pay taxes upfront, the long-term benefit is that your withdrawals are tax-free. This can provide more predictability and control over your retirement income, as you’re shielded from future tax hikes and state income taxes.

5. Investment Growth and Tax-Free Withdrawals:

• Since all growth in a Roth 401(k) is tax-free, you may come out significantly ahead by the time you retire, especially if you experience significant investment growth over the decades. This tax-free growth can make a massive difference in your retirement income in a state with high taxes.

Summary:

• Roth 401(k): Contributions are taxed today, but withdrawals in retirement are tax-free, which allows you to avoid paying state income taxes when you retire in a state with income tax.
• Pre-tax 401(k): Contributions reduce your taxable income today. However, contributions and earnings are fully taxable when withdrawn, meaning you could face higher state income taxes in retirement.

For someone living in a no-income-tax state and planning to retire in a state with income taxes, choosing the Roth 401(k) can be a powerful way to maximize your retirement savings and minimize taxes over the long term. I have stopped all pre-tax funding for my wife and me and added to a Roth 401(k). This way, we pay the taxes now and do not have to worry about them in retirement, even though we are in the higher tax brackets.

About Chris

Chris Heisten is the President and Founder of Heisten Financial LLC, a fee-only financial planning firm focusing on giving clients back their time so they can spend it doing what’s most important to them. Acting as a true fiduciary for his clients, Chris aims to solve their financial pain points by incorporating tax planning saving strategies and moving them toward financial freedom. In the financial industry since 2007, Chris has partnered with families with the same questions and complexities as he and his family. He guides the journey through life, striving to instill calmness and a sense of direction as he simplifies the complex. He loves seeing clients experience relief when they achieve what they thought was impossible.

Chris graduated from the University of Maine, where he played hockey on a scholarship, and retired from professional hockey in 2007. In the community, he remains engaged, serving as a youth hockey coach. Chris holds the CERTIFIED FINANCIAL PLANNER™. Outside the office, he enjoys trying new food and wine, reading, traveling, playing golf and hockey, fat tire biking, and donating to local charities. His passions include being a husband and dad, lake life with the family, watching his son and daughter play sports, and spending time with his wife. To learn more about Chris, connect with him on LinkedIn or contact our team at Heisten Financial today.