Difference Between Pre-Tax Vs. After-Tax Investments
When discussing retirement plans and taxes, you often hear the terms “pre-tax” or “after-tax” dollars. What do these terms mean... and how do you know what is pre-tax vs. after-tax?
After-tax dollars are pretty easy to understand. If you earn the money, pay income tax on it, and then deposit it into some type of account, or buy an investment with it, you have used after-tax dollars. These types of accounts can be savings accounts, brokerage accounts, or mutual fund accounts.
The original amount you invest is called your cost basis, or principal. When you cash in an after-tax (non-retirement account) investment, you only pay tax on any investment gain above your original investment amount.
When you use after-tax money to purchase investments that typically deliver investment returns in the form of qualified dividends and long-term capital gains, you may pay fewer taxes over the long haul–these types of investment income are subject to a lower tax rate–and in some cases, long-term capital gains are not taxed at all.
When you have funds in an after-tax account you will receive a 1099 tax form from your financial institution each year. This 1099 form will show you the interest income, dividend income and/or capital gains earned for that year. These investment income items must be reported on your tax return each year. After-tax dollars can be invested in just about anything: CD’s, savings accounts, mutual funds, stocks, bonds, real estate, annuities, and much more.
Pre-tax dollars means money you or your employer have put into some type of retirement accounts such as IRAs, 401(k) plans, or other retirement plans like pensions, profit sharing accounts, 457 plans or 403(b) plans. You have not yet been taxed on this money.
For example, if your taxable income was going to be $40,000 and you put $2,000 in a pre-tax account like a deductible IRA, then your reported taxable income for that year would be $38,000. The IRS rules allow you and/or your employer to put only a certain amount (which varies by the type of account) into these pre-tax vehicles each year.
The funds inside of such pre-tax accounts grow tax-deferred, so you do not get a 1099 tax form each year, and you do not have to pay tax on the interest income, dividend income and/or capital gains earned until such time as you take a withdrawal.
Tax deferral is good because you get to earn interest on funds that you would otherwise have to pay to Uncle Sam.
The downside of pre-tax accounts is that you do not get to take advantage of the lower tax rates that apply to qualified dividends and long-term capital gains. Investment income inside of pre-tax accounts is all taxed the same way - as ordinary income upon withdrawal.
When you take an IRA withdrawal from a pre-tax account, the entire withdrawal will be taxable income in the calendar year you take it (transfers and rollovers when done right do not count as withdrawals).
It is required that a pre-tax retirement account has to have a custodian. It is the custodian’s job to report to the IRS the total amount of contributions and withdrawals that are made to, or taken from these retirement accounts.
The custodian, or financial institution, that holds your pre-tax account will send you and the IRS a 1099-R tax form in any year that you take a withdrawal. If you take a withdrawal from a pre-tax account early (generally before 59 1/2) then an early withdrawal penalty tax may also apply in addition to regular income taxes on the withdrawn amount.
Within a pre-tax account, you can buy numerous types of investments such as CD’s, annuities (fixed, variable or immediate), mutual funds, stocks, and bonds. Employer hosted pre-tax accounts like 401(k) plans may limit your available investments to a pre-selected list of mutual funds.
You can also have accounts that have a combination of pre-tax and after-tax dollars. They are called tax-deferred accounts.
Tax-deferred accounts are funded with after-tax dollars, but once funded, just like with pre-tax accounts, you do not have to pay tax on the interest income, dividend income, and/or capital gain earned until such time as you take a withdrawal.
This investment income is deferred until withdrawal - however, just as with -pre-tax accounts, the downside is that all investment income is taxed the same way upon withdrawal - as ordinary income. The most common type of tax-deferred savings vehicles are fixed and variable annuities, and non-deductible IRA accounts.
In retirement planning, many financial planners suggest a combination of pre-tax and after tax accounts. A Roth and Traditional IRA, for example. Having both allows you to partially protect against the future direction of tax rates and your net worth. If you believe that tax rates will be higher in the future and/or your income will be higher, it's better to pay taxes now (after-tax) instead of later. (Pre-tax).
If you believe that tax rates will be lower and/or your net worth will be higher, it's better to pay taxes later (Pre-tax) instead of now (After-tax)
Of course, very few financial rules are so general that individual financial profiles aren't important. Speak to your financial planner about the right way to structure your accounts.