Understanding Pre-Tax and After-Tax Investments
When discussing retirement plans, you may hear the terms “pre-tax” or “after-tax” concerning investment accounts. Knowing the difference between the two will help you maximize your dollars and minimize your tax burden.
Here's how to tell the difference, and how to use both to your advantage.
With a pre-tax account, you or your employer put money into a retirement account before taxes are assessed. These are also known as "tax-deferred" accounts because you defer paying taxes until you withdraw from the account in the future. The idea is that you will be in a lower income tax bracket in retirement, so you'll enjoy more favorable tax rates at that point than you would during your peak earning years. By deferring taxes, you hope to reduce your overall tax bill on the funds in the account.
Pre-tax accounts include:
You have not yet been taxed on the money you deposit, so they are called "pre-tax." Within a pre-tax account, you may be able to choose from many different types of investments, such as:
- Annuities (fixed, variable or immediate)
- Mutual funds
Not all of these investments are available in every pre-tax account. Employer-hosted pre-tax accounts such as 401(k) plans, for example, may limit the available investments to a pre-selected list of mutual funds.
Pre-Tax Account Considerations
Your pre-tax contributions lower your taxable income by the amount deposited. For example, if your taxable income was going to be $40,000 for a given year, and you put $2,000 of it in a pre-tax account such as a traditional IRA, then your reported taxable income for that year would be $38,000. The IRS caps the amount you can deposit into these pre-tax vehicles each year, and it varies by account as well as by your age.
Not only do pre-tax contributions lower your taxable income for that year, but you do not have to pay tax on the interest income, dividend income, or capital gains until you make a withdrawal. Deferring your taxes this way gives your principal time to grow and accrue interest.
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, for example, an IRA withdrawal from a pre-tax account, the entire amount of the withdrawal will be taxable income in the calendar year you take it (transfers and rollovers, when done correctly, do not count as withdrawals).
Pre-tax retirement accounts must have a custodian, or financial institution, whose job it is to report to the Internal Revenue Service (IRS) the total amount of contributions and withdrawals for the account each year. The custodian that holds your pre-tax account will send you and the IRS a 1099-R tax form in any year that you make a withdrawal. If you take a withdrawal from a pre-tax account early (typically, before age 59 1/2), then a penalty tax may also apply. This penalty is generally 10%.
With after-tax dollars, you earn the money, pay income tax on it, and then deposit it into some type of account where it can earn interest.
Examples of these kinds of accounts include:
- Savings accounts
- Money-market accounts
- Regular, taxable brokerage accounts (where you can buy just about any investment: mutual funds, stocks, bonds, annuities, and so on)
- Roth IRAs
The original amount you invest is called the principal. In a taxable investment account, this is also known as your cost basis. When you cash in an after-tax (non-retirement account) investment, you only pay tax on any investment gain above your original investment amount.
However, even within after-tax accounts, not all gains are taxed the same. Generally, the longer you hold an investment, the more favorable your tax situation. Long-term investments deliver returns in the form of qualified dividends and long-term capital gains, and 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-DIV or 1099-INT form from your financial institution each year. This 1099-DIV or 1099-INT form will show you the interest income, dividend income, and capital gains earned for that year, if any. This investment income must be reported on your tax return each year.
Most retirement accounts are pre-tax accounts—you get a tax break upfront for saving. Roth IRAs are an exception. These accounts are funded with after-tax dollars, but they offer significant tax benefits to those who wait until retirement to withdraw from them.
For example, while brokerage accounts tax capital gains, Roth IRAs allow holdings to grow tax-free. As long as you withdraw from the account properly, you won't pay any taxes on capital gains or dividends acquired within the account.
Using a Combination of Accounts
For retirement planning, some financial planners will suggest a combination of pre-tax and after-tax accounts—using both a Roth IRA and Traditional IRA, for example. Having both is a method of tax diversification, helping you to hedge against a change in tax rates as well as a change in income level in the future.
Contributing to a pre-tax account now may mean your investment and earnings will be taxed at a lower rate later, in your retirement years. On the other hand, using an after-tax account now means you've already paid the tax on your contributions.
Of course, these financial guidelines are quite general, and your personal financial profile must be taken into account. Speak to your financial planner about the right way to structure your accounts.