The decision whether to invest in pre-tax versus after-tax retirement plans is often a complicated one. At the end of that day it all comes down to taxes. Will you be better of paying taxes on the money now or in the future? To this question we say it all depends on your personal tax situation.
What are the different plan options under each?
Examples of pre-tax options are traditional IRAs, 401(k) plans, SIMPLE IRAs, and SEP plans. Examples of after-tax options are Roth IRAs and Roth 401(k) plans. In both plan options earnings are either tax free or only taxable upon withdrawal in retirement so there are not current tax implications on earnings like with brokerage accounts. Keep in mind that tax-deferred (paying taxes when money is withdrawn in retirement) is not the same as tax free. Regardless of the plan chosen or offered, it is important to know the benefits of both pre-tax and after-tax contributions to retirement plans.
· Tax savings happen now. For each dollar that is put into the plan you will save a percentage based on your Federal and state tax rates on your individual income tax return. For example, for an individual in the 15% tax bracket for Federal and 5.8% for NC they will save $2,080 on a $10,000 pre-tax retirement contribution.
· Contributions are taxed at a lower rate in retirement. Typically employment years are when taxable income is going to be the highest. The idea is to save money at the higher rate now and pay taxes on withdrawal at a lower retirement rate in the future. This benefit greatly depends on where you expect income tax rates to be in the future.
· Tax-free income comes out in retirement. Not only do the contributions come out tax free, but the earnings do as well! With pre-tax contributions the earnings are taxed when pulled out at retirement.
· Penalty free withdrawals are allowed on contributions. In the event of a life emergency and retirement funds need to be used, the contributions can be pulled out tax and penalty free. Taxes and the 10% early withdrawal penalty apply only on the earnings unless used for: first-time home purchase up to $10,000, higher education expenses, disability, death, back taxes, and unreimbursed medical expenses that exceed 10% of adjusted gross income
· No required minimum distributions and you can contribute after age 70 ½ as long as you are working.
· Income limitations for the Roth IRA can be circumvented by first making a traditional IRA contribution in any given tax year and then converted to a Roth. This can be complicated so we suggest working with a financial advisor to make these types of conversions.
After-tax or Roth contributions may seem like the better option due to the benefits above. However, the majority of employers are only offering pre-tax plans. If your employer only offers a pre-tax option with a matching provision then your choice is made easier. However, it is important to understand the tax effects of both types of plans to properly prepare for your retirement future!