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The way you invest can affect how much you owe in taxes. Some investment accounts offer tax breaks today, while others help reduce your tax liability in retirement. Each has its own pros and cons. Finding the right balance is an important part of managing your money, especially when you're relying on your nest egg for income. Here's how to decide between pretax and after-tax investing.
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What Is Pretax Investing?
Pretax investments, which are sometimes called tax-deferred investments, are funded with money you haven't paid taxes on yet. With a 401(k), for example, contributions are typically made through automatic payroll deductions. That money is taken directly from your gross pay, before taxes are deducted, which reduces your taxable income—and, in turn, brings down your tax liability.
When you invest with pretax income, it can help you keep more money in your pocket during your working years. But you can expect a tax bill later. You'll generally owe taxes when you withdraw funds from a tax-deferred account. One exception: Withdrawals from a health savings account (HSA) are tax-free if used to cover qualified medical expenses.
Pros of Pretax Investing
- Contributions are generally tax-deductible. That can reduce your taxable income during your working years, when you're likely to pay more in taxes.
- Employer-sponsored accounts like 401(k)s may offer an employer match.
Cons of Pretax Investing
- Withdrawals you make in retirement will be taxed as ordinary income.
- Taking out too much could push you into a higher tax bracket.
- Tapping your account before age 59½ will likely trigger a 10% penalty.
- Required minimum distributions (RMDs) generally apply to tax-deferred accounts. RMDs require you to start making withdrawals at age 73, even if you don't need or want to withdraw money.
Examples of Pretax Accounts
What Is After-Tax Investing?
After-tax investments are funded with money you've already paid taxes on. If you're an employee who receives a W-2, federal taxes should be automatically deducted from your paycheck. The same goes for state taxes, if they apply. If you take some of your earnings and invest through a brokerage account or Roth IRA, you'll be doing so with after-tax dollars.
The main advantage of after-tax investing is that it can unlock tax- and penalty-free retirement income. For example, you can tap Roth IRA contributions at any time, free and clear. However, you may be taxed on investment earnings if you've had the account for less than five years and are under 59½.
Pros of After-Tax Investing
- After-tax investments can be a great source of retirement income because they generally don't trigger a tax bill.
- Roth IRAs offer tax-exempt growth. That means you won't pay taxes on dividends or capital gains.
- Brokerage accounts have no contribution limits or withdrawal penalties, though you'll likely be taxed on investment gains.
Cons of After-Tax Investing
- Contributions are not tax-deductible.
- IRAs have much lower contribution limits when compared to 401(k)s.
- Roth IRAs are not available through an employer. However, some employers offer a Roth 401(k) option, which could include an employer match.
Examples of After-Tax Accounts
How to Choose Between Pretax and After-Tax Investments
The goal is to strike a balance between the two. If all of your nest egg is in pretax accounts, every withdrawal you make in retirement will be considered a taxable event. This could create a significant expense that takes a big bite out of your savings. But if you save strictly in after-tax investments, you could miss out on attractive tax perks and employer contributions during your working years. Having a mix of pretax and after-tax investments can help you secure tax benefits today—while shielding you from hefty tax bills in retirement.
Consider the following factors when deciding what's best for you:
- Do you expect your tax bracket to be higher during your working years or in retirement? If your income is higher today, tax-deductible contributions to pretax accounts could be a nice perk that reduces your taxable income.
- Is a 401(k) on the table? If you have access to a 401(k), opting in is an easy way to save for retirement. An employer match, which is essentially free money, can be a cherry on top.
- Are you maxing out your retirement accounts? If you've contributed the maximum amount to your 401(k) and IRAs, a brokerage account may be worth considering. This after-tax account can be used to invest in stocks, bonds, exchange-traded funds (ETFs), mutual funds and more.
The Bottom Line
If you're torn between pretax and after-tax investing, ask yourself if both options are possible. Exploring both can help you grow your wealth in the most tax-efficient way. That could help you secure tax benefits today while setting yourself up for a tax-friendly retirement.
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