Understanding the difference between pre-tax and after-tax
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.
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.
A key benefit of a pre-tax retirement savings account is the potential to reduce your taxable income today, and not pay taxes until you withdraw your money.
After-tax retirement savings accounts
A good example of an after-tax retirement account would be a Roth IRA. 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 receiving after-tax benefits 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 tips 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 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 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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