Pre-Tax Vs. After-Tax Investments
When planning retirement plans and discussing taxes for retirement you often hear “pre-tax” or “after-tax” dollars. How do you know what is pre-tax vs. after-tax?
After-tax dollars are 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.
Examples of these accounts are 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 and beyond 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.
Pre-tax dollars are 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 been taxed on this money, therefore making it "Pre-Tax".
For example, if your taxable income was going to be $50,000 and you put $3,000 in a pre-tax account like a deductible IRA, then your reported taxable income for that year would be $47,000. This enables you to put away more money than you would have otherwise as well as lower your effective tax rate.
If you make $100,000 and put $10,000 into a 401k, you are then only taxed as if you only made $90,000 rather than $100,000, which lowers your rate. Therefore, you are only missing $7000 or $8000, rather than $10,000.
A single mom with a child in college has an AGI of $95,000 - by contributing $15,000 to her 401k she accomplishes 2 things:
1) She would have paid 24% rate on that $15,000, so her out of pocket cost is only $11,400
2) Additionally, she gets the American Opportunity Credit for her child’s college expenses
The amount she gets now is approximately $2,500, since she lowered her AGI below $90,000. She would have received $0 if her AGI was above $90,000.
Now her out of pocket amount for the $15,000 is only $8,900! This is approximately 60% of the $15,000; she is saving approximately 40% of the $15,000 (about $6000). Which is a much larger savings than her 24% tax rate!
This example shows the true power of contributing to a 401k or IRA.
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.
Pre-tax accounts do have a downside: 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. This type of income typically has higher tax rates.
Whether to contribute to a Tradional 401k, a Roth 401K, Traditional Deductible IRA or a Roth IRA, is up to each taxpayer’s individual personal situation.
However, if one is purchasing a growth stock which does not really kick off Interest and dividends, and has the discipline to never sell and use it, then it would be much better to keep it in an “After Tax account” than a Non Deductible IRA. This kind of IRA is to defer any interest, dividends, and Capital gains. However, there is no tax benefit when actually contributing the money in.
The taxes upon distribution will be taxed at a much higher rate than the capital gain rate in the “After Tax account”.
At such time as you take an IRA withdrawal from a pre-tax account, the entire withdrawal will be taxable income in the calendar year you take it.