Choosing the right type of tax advantage can have a big impact on your investment returns and current budget.
Some plans offer tax benefits by allowing you to deduct the income tax contribution in the year you make it. With other plans, usually Roth IRAs or Roth 401(k)s, you contribute after-tax money, but then you withdraw it into retirement, including the income. , tax free.
Each type of tax benefit has its advantages and disadvantages. Learn more about how pre-tax and after-tax contributions work and what type of retirement plan might be right for your situation. That way, you can maximize your returns and stay financially healthy as you reach your retirement goals.
- You can contribute to a tax-deductible retirement fund with pre-tax or after-tax income.
- Traditional IRAs and 401(k)s allow you to deduct your contributions from income taxes in the year you contribute.
- With a Roth account, you contribute to the income, but you can withdraw from your account in retirement without paying taxes.
- You must be at least 59½ to withdraw money from a traditional IRA or 401(k) account without penalty.
How Pretax and Roth Contributions Work
Whether you contribute pre-tax to a regular account or contribute after-tax to a Roth account, you can get a tax advantage. But the type of tax benefit you get depends on the type of account you choose.
Contribution before tax
With pre-tax contributions, your profits will be immediate. You can deduct your contributions against your taxable income and reduce your tax bill throughout the year. This can help give you more money that you can use for other expenses.
People who can benefit from an immediate tax break may prefer to make pre-tax contributions to a retirement account such as a traditional IRA or 401(k). Then, when you withdraw your money in retirement, the money is taxed as income according to your income tax bracket at that time.
You can’t take money out of a traditional retirement account before you’re 59½ or you’ll face penalties. You must also begin taking required minimum distributions (RMDs) at age 72.
With Roth account contributions, the money is included in your taxable income for that year, so you don’t see an immediate tax benefit. However, during retirement, you can take tax-free withdrawals from the Roth account, including potential investment gains.
For investors who have a longer investment horizon, or more time to grow their investments, a Roth account designed with after-tax funds may provide more benefits in retirement. In fact, even if the portfolio has made significant gains, the investor does not have to pay taxes when withdrawing them.
You can withdraw your Roth IRA contributions at any time because you’ve already paid taxes on them. However, you must wait until age 59½ and have owned the account for more than five years before you can withdraw your income tax-free. If you make an early withdrawal, you will have to pay income tax. Roth IRAs do not require you to withdraw money until the account owner dies.
To calculate the difference in savings between a traditional IRA before taxes and a Roth IRA after taxes, you can use one of the free online calculators available from many banks and unions.
The Pros and Cons of Pretax and Roth Contributions
Understanding the difference between pre-tax and after-tax contributions will help you choose which type of tax-advantaged plan is right for your situation.
Pre-tax contribution margin
A major benefit of making pre-tax contributions to a traditional IRA or 401(k) is that it lowers your tax bill that year. You can contribute up to $6,500 to a traditional IRA or up to $22,500 to a 401(k) for 2023. The amount of tax you save depends on how much you contribute and how much you contribute. amount of taxable income for that year. There is no limit on how much money you can contribute to a regular account.
Lack of pre-tax contributions
The downside to pre-tax contributions rather than after-tax contributions is that you cannot withdraw the income tax-free in your retirement years. If you’re younger and invest longer, the savings you’ll get in retirement by contributing to a Roth account now can be much more than the savings you’ll get by contributing before. the tax.
In accounts that contribute before taxes, you usually have to start taking minimum distributions starting at age 72. You may get an exception to this rule if you are still employed, but you cannot leave your money in these accounts indefinitely.
Benefits of Roth Contributions
The biggest advantage of a Roth account is that it allows your investment income to grow tax-free. No matter how big your gains are, you don’t have to pay tax on them when you withdraw money in retirement. Having a tax-free income in retirement can be a great benefit to help you pay for your living or living expenses.
A Roth IRA has no required minimum distribution, so you can keep your money tax-free until you die, when your account is drawn out and passed on to your heirs.
Lack of Roth Contributions
The main disadvantage of contributing to a Roth with after-tax funds instead of a traditional account is that your tax benefits are delayed until retirement age. Therefore, you cannot reduce your tax bill in the year you make your contribution. If you have a lot of money and carry a lot of debt, the lack of tax benefits can be a big disadvantage of contributing to a Roth.
Another disadvantage of contributing to a Roth IRA is that these accounts have income limits. You must have a modified adjusted gross income (MAGI) of $228,000 or less for applicants with taxes and $153,000 or less for single applicants. If your income is high, you cannot participate.
A designated Roth 401(k) account has a required minimum distribution if you are not employed and do not own 5% of the company.
Can you make pre-tax and Roth contributions?
You can contribute to traditional pre-tax accounts and Roth accounts, but your total contributions must not exceed the maximum IRS limit.
Can you open both accounts in one year?
If you have both a traditional IRA and a Roth IRA, you can only contribute the total of the total of the two accounts combined. So, for 2023, the most people can contribute is $6,500. So you can contribute $3,250 to a traditional IRA and a Roth IRA, but you can’t contribute $6,500 to both.
Can you convert a traditional IRA to a Roth IRA?
You can roll over money from a traditional IRA to a Roth IRA. This can be a good strategy if you expect your tax bill to be higher in the future. You owe tax on any money you convert.
The bottom line
The key to saving for retirement is to start as early as possible. Choosing the right type of retirement plan, whether using pre-tax funds or post-tax contributions, can help you reach your financial goals. Consider consulting a financial professional for advice on what type of plan is right for your needs.