Pre-tax vs. after-tax contributions
When it comes to saving for retirement, you have many different choices in retirement accounts. And to give you even more to think about, most retirement accounts come with their own rules and tax benefits.
While this article isn't meant to be a comprehensive guide to each type of retirement account, it may help you have a better understanding of the key differences between pre-tax and after-tax accounts which could help you optimize your tax strategy and offer tax advantages during your retirement.
What are pre-tax contributions
Pre-tax contributions are funds that are taken from your gross income before any taxes are deducted and deposited into a retirement account, such as a traditional IRA or 401(k). Because these contributions are made with pre-tax dollars, you can put off paying taxes on the money you contribute to these types of accounts, including any potential earnings they may generate.
Benefits
- Immediate tax savings — By reducing your taxable income, pre-tax contributions can lower your current income tax liability.
- Tax-deferred growth — Investments in these accounts can grow income-tax free until withdrawal, allowing for potentially greater compound growth over time.
- Potential employer contributions — In an employer-sponsored retirement plans like 401(k)s, employers often match a portion of your contributions that further boost your retirement savings.
Drawbacks
- Taxable withdrawals — Withdrawals from pre-tax retirement accounts are subject to income tax, meaning you will owe taxes of the distributions during retirement.
- Required Minimum Distributions (RMDs) — Starting at age 73, you must begin taking RMDs from your IRAs and 401(k). Failing to do so could result in penalties.
- Penalties for early withdrawal — Withdrawals made before age 59 ½ from pre-tax accounts are generally subject to a 10% early withdrawal penalty in addition to regular income tax which could significantly reduce the amount of money you have saved for retirement.
Pre-tax retirement savings accounts
Also known as tax-deferred accounts, pre-tax retirement accounts generally include traditional individual retirement accounts (IRAs) and 401(k)s. The term pre-tax means that you can put off paying taxes on the money you contribute to these types of accounts, including any potential earnings they may generate. When you're ready to retire and begin to make withdrawals from a pre-tax retirement account (referred to as distributions), you will pay taxes on this money as it is considered taxable income.
What are 401(k)s?
A 401(k) is a retirement account that's made available to employees who wish to save for their retirement (provided their employer offers a plan). In this case, it's the employer that holds back a part of your salary (tax-deferred) and invests those dollars on your behalf. Some employers are even willing to match the contributions made by their employees with their own money. Since 401(k) plans are meant to encourage you to save for retirement, there are heavy tax penalties imposed for early withdrawals (before age 59½).
What are traditional IRAs?
A traditional IRA (Individual Retirement Account) is a personal savings plan under U.S. tax code law that allows you to set aside money for retirement and offers tax advantages. With a traditional IRA, you may be able to deduct some or all of your contributions from your taxable income and may also be eligible for a tax credit equal to a percentage of that contribution. Amounts in a traditional IRA, including earnings, can grow tax-deferred. Amounts you withdraw from your IRA are fully or partially taxable in the year you withdraw them.
What are after-tax contributions?
After-tax contributions are funds that you contribute to a retirement or investment account using income that has already been taxed. Unlike pre-tax contributions, these funds do not reduce your taxable income for the year in which they are made. However, the contributions will not be taxed again upon withdrawal, although earnings on these contributions may be subject to taxes, depending on the type of account.
Benefits
Drawbacks
- No immediate tax deduction — After-tax contributions do not provide an immediate tax benefit, as they do not reduce your taxable income for the contribution year.
- Tax on earnings — Earnings are subject to tax.
- Limited contribution limits — Annual contribution limits and income limits may restrict high earners from contributing.
After-tax savings accounts
A good example of an after-tax retirement account would be a Roth IRA.
What are Roth IRAs?
A Roth IRA is a type of retirement savings account that offers unique tax advantages. Unlike traditional IRAs, contributions to a Roth IRA are made with after-tax dollars, meaning they are not tax deductible.
For example, during the accumulation phase (the time when you are building up your retirement savings) any contributions that you make to your Roth IRA are made with after-tax dollars. In other words, you'll have already paid taxes on those contributions. Therefore, when retirement rolls around, qualified distributions will be tax-free (in accordance with IRS guidelines).1
One of the perks of making after-tax contributions is being able to better hedge against the possibility of being in a higher personal tax rate when you retire. For example, if you have a pre-tax 401(k) account and your tax rate in the future turns out to be higher, you may find yourself paying more taxes when you withdraw your money.
Tax considerations to manage retirement more effectively
There are many factors to consider regarding taxes during retirement. Do some research to understand some important elements that may impact the level of taxes you pay.
Investigate tax brackets – Understand tax brackets and the income thresholds for each to get a baseline of the taxes you’ll pay based on your retirement income. As you make withdrawals from your retirement accounts, stay mindful of those thresholds so you don’t inadvertently advance yourself into a higher tax bracket.
Research tax advantages of different types of income – Income from selling a home that has increased in value may be sheltered up to a certain amount. Capital gains from an investment in property, gold or other capital asset may be taxed at a lower rate than ordinary income.
Start early – Tax planning for retirement starts now. Take time to investigate the different tax implications of a variety of investments. By strategically planning now for retirement in a few decades, you can make important decisions that today that will help minimize tax implications later.
Check with your financial professional while saving for retirement
There are many different types of retirement plans, each with different rules concerning contributions, distributions, and taxation. When it comes to retirement planning, speak to your financial professional and/or tax professional who can help you design a strategy that's best for you.
1. http://www.irs.gov/publications/p590b/ch02.html#en_US_2014_publink1000231057
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