Regístrese ahora para una mejor cotización personalizada!

What do 'pre-tax' and 'post-tax' mean? And why should you care?

Dic, 10, 2021 Hi-network.com

Almost every article you read about retirement savings mentions the terms "pre-tax" and "post-tax" savings, often referencing them with no explanation of what they mean or why they're important. So let's start from the beginning and work through what those terms mean -- and what they mean for your retirement.

Most people have a few options for saving for retirement. You can, of course, save your money in an ordinary savings account if you'd like, but doing so means there's no extra benefit in terms of your taxes. 

Recommends

  • The 5 best VPN services (and tips to choose the right one for you)
  • The best AI art generators: DALL-E 2 and other fun alternatives to try
  • The best Android phones you can buy (including a surprise pick)
  • The best robot vacuum and mop combos (and if they're worth the money)

Some people have access to a retirement plan through work, often called a 401(k) , a 403(b) if they work for a nonprofit, or a Thrift Savings Plan (TSP) if they work for the government. Outside of that, people who want to save for retirement have the option to open a traditional IRA.

All of those plans have a few things in common.

First, when you put money in a 401(k), you do not have to pay income taxes on that money that year. 

Let's say you make$50,000 this year and you decide to put$5,000 into your 401(k). Rather than paying income taxes on$50,000, you'll only have to pay it on$45,000 of your income. This is why, when you put money into this plan, it's called "pre-tax" money -- it comes out of your pay before taxes are calculated.

"Big deal," you say? Well, let's imagine you're a single person making$50,000 a year. If you don't contribute to your 401(k) plan at all, you're going to owe$5,719 in federal income taxes. If you contribute$5,000, however, you'll only owe$4,744 in federal income taxes.

Contributing to a "pre-tax" retirement account actually cuts down on the amount you owe. For most people, the effect of this is that each of their paychecks will be a bit lower. While some of your pay is in fact going into the 401(k), you also have less going toward taxes. Your take-home pay decrease a little, just not as much as your contribution.

That's the core idea behind "pre-tax" contributions; you don't have to pay taxes when you put in the money. 

But you do have to pay taxes when the money comes out of those accounts when you reach retirement age. At that point, your 401(k) acts like your employer does now. When you withdraw money from it, it'll be like a paycheck in the sense that taxes are taken out before you're "paid."

So, what about "post-tax" contributions? In general, that's what the word "Roth" indicates on retirement accounts. Roth IRAs, Roth 401(k)s -- you put your "post-tax" money into those accounts, meaning that it comes out of your paycheck after taxes are collected (or, in the case of a Roth IRA, straight out of your checking account). Your taxes don't go down at all this year.

Why would anyone choose to do that?The big benefit of a Roth account is that you don't have to pay any taxes when you take the money out when you reach retirement age, not even on the investment gains your money earned while in the account.It's all tax-free at that point.

For example, say you're retired and decide to start pulling$5,000 a year out of your Roth IRA. That's money you don't have to pay any taxes on; it's all "post-tax" money.

As you can see, both of these approaches offer some benefit over simply putting money in a savings account. 

A savings account is funded with post-tax money, which doesn't help you this year. And you have to pay taxes on any interest that you gain along the way.

Now, both IRAs and 401(k) accounts have restrictions on withdrawals. The big one is that your withdrawal options are very limited until you hit a retirement age of 59 and a half (or can provide clear proof that you've retired earlier than that), at which point there are almost no restrictions on withdrawals. In other words, if you're actually saving for retirement and use the account for that purpose, it's not a big deal.

Now the big question concerns whether it makes more sense to invest your money in a "pre-tax" retirement account or a "post-tax" account. Is it better to pay your taxes on that money this year and then have tax-free income in retirement? Or is it better to reduce your taxes this year but have to pay taxes on that money when you retire?

The honest truth is... I don't know. That's because there's one giant unknown that reigns over everything:We don't have any idea what tax brackets will look like in the future.No one knows what the tax rates will be in the future. Will they be higher? Will they be lower? Will they be lower for low-income earners and higher for high-income earners? It's impossible to predict.

I do, however, feel confident in believing the lower your income is in retirement, the lower your tax rate will be. The United States has used a progressive tax system since they started doing income taxes. A progressive tax system simply means that the less income you have, the lower your tax rate is. While it may become less progressive (meaning the tax rates between low-income earners and high-income earners become closer together) or more progressive (meaning that the rates become further apart or that there's a much higher cutoff before people have to start paying taxes), I think a higher income will always mean a higher tax rate.

Given that belief, I can make a few general recommendations that, while probably not perfect, are very likely to get you in the right account.

If your salary is entry-level or one that you realistically expect to get much higher later in your career, a Roth IRA or a Roth 401(k) is better for you right now. That's because you're already paying a low tax rate today, so you might as well take advantage of that. Sure, you might find out in retirement that your tax rate is even lower, but it can't be much lower -- and it certainly can be much higher.

On the other hand, if your salary is pretty strong and you don't anticipate enormous income jumps in the future, contributing to a normal 401(k)/403(b) or a traditional IRA is probably better for you. That's because you're paying a high tax rate today, so you're going to want to reduce your taxable income today. Sure, you might find out in retirement that your tax rate is even higher, but it probably won't be much higher -- and it certainly can be much lower.

There's one minor factor that trumps all of this, though: employer contributions. If your employer is matching your contributions to one of your retirement savings accounts, the value of that extra employer contribution money is going to blow away any tax benefits. It's not even close. So, if employer contributions are on the table, ignore all of this and chase those contributions. They're going to be worth more than the tax benefits even in the craziest of situations.

So, here's the takeaway:If your income is low and you expect it to go much higher, use a Roth. Otherwise, use a 401(k) or 403(b). The exception is employer contributions; do what you have to do in order to get all of those contributions. Follow this simple recipe, and you'll make a beneficial choice for retirement.

[This article was originally published on the Simple Dollar in January, 2019. It was updated in December, 2021.]

Taxes

The best free tax software: Your filing options comparedYour guide to filing taxes: Top tips for understanding the processHow donating to charity affects your tax billOur tax guide for college students: Help for first-time filers
  • The best free tax software: Your filing options compared
  • Your guide to filing taxes: Top tips for understanding the process
  • How donating to charity affects your tax bill
  • Our tax guide for college students: Help for first-time filers

tag-icon Etiquetas calientes: finanzas impuestos

Copyright © 2014-2024 Hi-Network.com | HAILIAN TECHNOLOGY CO., LIMITED | All Rights Reserved.