Tax Advantaged Retirement Accounts: Pre-Tax vs. After Tax
When you think about retirement savings plans, you may not think about taxes. However, retirement plans and taxes are very much related. The key is understanding different types of tax advantaged retirement accounts and what advantages pre-tax investments have over after-tax investments.
Let’s start with a brief explanation of tax advantaged retirement accounts:
Tax-advantaged retirement accounts come in many forms, including 401(k) plans, IRAs, pensions, profit sharing accounts, 457 plans or 403(b) plans. Some of these accounts allow for both pre-tax and after-tax contributions, while Roth accounts only allow for after-tax contributions. Be aware that each type of tax-advantaged retirement savings account has it’s own rules for making contributions and taking distributions. Failing to follow those rules can result in harsh financial penalties, which can negate the expected tax benefits.
Let’s define the two types of contributions:
1 – Pre-Tax
A pre-tax contribution is made with tax-deferred income. These contributions reduce your taxable income in the year of the contribution depending on the plan type, but you will eventually pay tax on the contributions and any earnings when you take the money out of the account. The contributions can be made by you or your employer (or both) to a qualified retirement account subject to limitations.
If you make contributions to an employer-sponsored plan, your employer will adjust your taxable income on your W-2. If you make contributions to a traditional IRA, you will be responsible for claiming the deduction on your tax return.
Deferring your taxes can be beneficial because it allows you to invest a larger amount of principal than you would have available if you paid tax in the year you earned the income. Another benefit of these accounts is that your earnings grow tax-deferred, which allows your balance to grow much faster than if you were to pay tax on earnings each year.
A negative of pre-tax contributions is you can’t take advantage of lower tax rates that typically apply to qualified dividends and long-term capital gains. In other words, when you do start taking distributions from your retirement accounts funded with pre-tax dollars, the entire distribution is taxed as ordinary income as opposed to capital gain which currently gets taxed at a lower rate. Another negative is that you don’t yet know what the ordinary income tax rates will be in later years due to the nature of tax policy. That bit of uncertainty means you could pay higher tax rates during your retirement years than the years in which you make the pre-tax contributions. On the other hand, even if rates increase in the future, your overall income may be lower when you retire.
When you withdraw money from a pre-tax account, you pay tax on the previously tax-deferred income, including pre-tax contributions and tax-deferred earnings.
Associated tax forms: You will not receive a Form 1099 to file with your tax return in the year of the contribution. However, you will receive a Form 1099-R when you withdraw the funds.
2 – After-Tax
An after-tax investment is made with income that is subject to tax in the year that it’s earned. For example, if you make money, pay income tax, and then deposit it into your retirement account,, you have made an investment with after-tax dollars.
While after-tax contributions don’t result in tax savings in the year of the contribution, they may result in tax savings in later years. For example, similar to pre-tax contributions, after-tax contributions to a tax-advantaged retirement account produce tax-deferred earnings as long as the funds remain in the account. With Roth accounts, those earnings remain tax-free in the year of the qualified distribution. When you take a withdrawal from an account that has both pre-tax and after-tax contributions, the withdrawal will be partly taxable and partly nontaxable.
Associated tax forms: Distributions from tax-advantaged retirement accounts will be reported on a 1099-R issued by the account administrator. The 1099-R may report your after-tax contributions in Box 5.
Practical Advice for Tax Advantaged Retirement Accounts
Consult with your financial advisor about the best way to structure your pre-tax and after-tax dollars. Then, work with an expert tax advisor who can guide you to make the best decisions based on your unique tax situation. Find an advisor now.