Many people don’t understand the ins and outs of their retirement plan—they simply contribute to their 401(k) and hope for the best. But while it’s normal to be a little confused by the investment landscape, that doesn’t mean you should settle for a less-than-optimal plan. Traditional Individual Retirement Accounts (IRAs) that allow for pre-tax contributions might be the most common type of retirement strategy, but that doesn’t mean they offer the best results in each phase of your life. When it comes to saving for retirement, you want to weigh the pros and cons of both traditional IRAs and Roth IRAs, which allow you to make post-tax contributions.
In this blog, we’re going to outline the differences between pre-tax contributions and post-tax contributions and how each of them can benefit your retirement goals in different ways.
We’ll start with the obvious: a pre-tax contribution is income you invest in your retirement account before you pay taxes on it. Traditional 401(k) programs are typically pre-tax investment accounts, though your employer might offer a Roth as part of its 401(k) program. Traditional IRAs are also referred to as “tax-deferred” plans because you pay taxes on them later.
A post-tax contribution is money you invest in your retirement account after you pay income tax. Roth IRAs are retirement accounts that allow you to invest your taxed income so you can withdraw “tax-free” money from the fund later (so long as it’s been five years since you started investing in the account and you’re 59.5 or older).
If you’re under age 50, you can contribute a maximum of $6,000 per year between these two types of accounts. (Once you’re 50 or older, that amount increases to $7,000 annually.) So if you divided your contributions evenly, you could invest up to $3,000 of pre-tax income in a traditional IRA and $3,000 of taxed income in a Roth.
Just like your other investments, it’s wise to diversify your retirement contributions into various types of funds. There’s no black and white answer as to whether pre-tax or post-tax contributions are better—that’s why it’s best to know how each type of account can help you achieve your goals in different stages of your life. Here are some things to consider:
Do you think taxes will be raised or lowered in the next 30 years?
We’ve posed this question to every client we’ve worked with, and practically everyone predicts taxes will rise in the future. (Those who don’t say “taxes will rise” typically answer, “I’m not sure.”) With increasing budget deficits, it stands to reason that taxes would likely increase in the future. With that in mind, you have to ask yourself whether you’d prefer to pay your income tax now—when you have a lower tax rate—or later, when it’s likely your tax payments will be higher.
If you’re young and you have years ahead of you to save, it might make more sense to focus on post-tax contributions—your tax rate is likely lower than it will ever be in the future, and you have plenty of time for your contributions to grow.
Conversely, if you’re nearing retirement (and are now making a higher income than in previous years), you might want to allocate more to pre-tax contributions. Similarly, if you’re in sales, real estate, or another industry where your income fluctuates year-to-year, knowing how to minimize your tax burden accordingly is incredibly important. By making pre-tax contributions in a high-income year, you reduce your taxable income for that year. Plus, you can write off those contributions on your next tax return, both of which help you save a little money from Uncle Sam.
In years you make a little less money, you might want to take advantage of post-tax contributions or convert some of your pre-tax dollars to a Roth. Since the amount you convert to a Roth counts as taxable income in the year you transfer the funds, you’ll pay those taxes, but it should even out since you’re making less and therefore being taxed less that year.
While most of us assume taxes will rise in the future, no one knows exactly how tax laws will change in the next 20 or 30 years. And one thing many people don’t consider when they make pre-tax contributions is that they invite a partner to share in their retirement—and that partner is the IRS.
When you make pre-tax contributions, you still have to pay taxes on that money at some point (in this case, when you withdraw the funds or transfer them to a Roth). As such, the IRS essentially earns a percentage of your savings in retirement, and only they have the power to determine what that percentage is. So if you save $1 million for your retirement, only part of that is yours; the rest now belongs to Uncle Sam.
As such, you must plan your retirement according to not only how much you’ve saved, but how much you’ll lose in taxes. On top of that, you’ll want to account for changes in tax law—you may expect one rate now, but that could change by the time you retire. (We discuss this concept in another blog, “What you’re Failing to Consider About Your Future Part III.”) If your tax bracket or the tax law changes dramatically from the time you begin investing to the time you retire, you could end up having to make a major adjustment to your retirement lifestyle when it comes time to pay your taxes.
While most of us assume taxes will rise in the future, no one knows exactly how tax laws will change in the next 20 or 30 years. And one thing many people don’t consider when they make pre-tax contributions is that they invite a partner to share in their retirement—and that partner is the IRS.
When you make pre-tax contributions, you still have to pay taxes on that money at some point (in this case, when you withdraw the funds or transfer them to a Roth). As such, the IRS essentially earns a percentage of your savings in retirement, and only they have the power to determine what that percentage is. So if you save $1 million for your retirement, only part of that is yours; the rest now belongs to Uncle Sam.
As such, you must plan your retirement according to not only how much you’ve saved, but how much you’ll lose in taxes. On top of that, you’ll want to account for changes in tax law—you may expect one rate now, but that could change by the time you retire. (We discuss this concept in another blog, “What you’re Failing to Consider About Your Future Part III.”) If your tax bracket or the tax law changes dramatically from the time you begin investing to the time you retire, you could end up having to make a major adjustment to your retirement lifestyle when it comes time to pay your taxes.
Ultimately, there are pros and cons to each type of contribution. Pre-tax investments allow you to save some money now (and potentially invest more than you might otherwise be able to), while post-tax contributions can provide more stable and consistent retirement funds. What works best for your overall goals will depend on your current situation, which is why it’s best to know the advantages of each type of investment.
While you can’t always avoid “partnering” with the IRS, you can choose to partner with someone with the right expertise, who also has your best interest in mind. If you’d like to discuss your retirement goals in greater detail, we’d love to help you find the best plan for you. Give us a call or click the button below to schedule a consultation.
125 W. Romana Street, Suite 720
Pensacola, FL 32502
Phone: (850) 542-4803