Understanding Pretax vs. After-Tax Investing: Pros and Cons

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What Is Pretax Investing?

Pretax investments, also known as tax-deferred investments, are funded with money that hasn’t been taxed yet. For instance, contributions to a 401(k) are typically made through automatic payroll deductions, directly from your gross pay before taxes are deducted. This reduces your taxable income and, consequently, your tax liability.

Investing with pretax income can help you retain more money during your working years. However, you will generally owe taxes when you withdraw funds from a tax-deferred account. An exception is withdrawals from a health savings account (HSA) used for qualified medical expenses, which are tax-free.

Pros of Pretax Investing

• Contributions are generally tax-deductible, reducing your taxable income during your working years.
• Employer-sponsored accounts like 401(k)s may offer an employer match.

Cons of Pretax Investing

• Withdrawals in retirement will be taxed as ordinary income.
• Large withdrawals could push you into a higher tax bracket.
• Early withdrawals before age 59½ may incur a 10% penalty.
• Required minimum distributions (RMDs) apply to tax-deferred accounts, starting at age 73.

Examples of Pretax Accounts

• 401(k)
• 403(b)
• 457 plan
• Traditional individual retirement account (IRA)
• HSA
• 529 savings plan

What Is After-Tax Investing?

After-tax investments are funded with money that has already been taxed. For employees receiving a W-2, federal and state taxes (if applicable) are automatically deducted from their paycheck. Investing through a brokerage account or Roth IRA involves using after-tax dollars.

The main advantage of after-tax investing is the potential for tax- and penalty-free retirement income. For example, Roth IRA contributions can be accessed at any time without taxes or penalties. However, investment earnings may be taxed if the account is less than five years old and the account holder is under 59½.

Pros of After-Tax Investing

• After-tax investments can provide tax-free retirement income.
• Roth IRAs offer tax-exempt growth, meaning no taxes on dividends or capital gains.
• Brokerage accounts have no contribution limits or withdrawal penalties, though investment gains are taxable.

Cons of After-Tax Investing

• Contributions are not tax-deductible.
• IRAs have lower contribution limits compared to 401(k)s.
• Roth IRAs are not employer-sponsored, though some employers offer a Roth 401(k) option with potential employer matches.

Examples of After-Tax Accounts

• Roth IRA
• Roth 401(k)
• Brokerage account
• Certificate of deposit (CD)
• Money market account
• Savings account

How to Choose Between Pretax and After-Tax Investments

The goal is to balance both types of investments. If all your savings are in pretax accounts, every retirement withdrawal will be taxable, potentially creating a significant expense. Conversely, relying solely on after-tax investments may mean missing out on tax perks and employer contributions during your working years. A mix of pretax and after-tax investments can help you secure tax benefits today while minimizing tax bills in retirement.

Consider these factors when deciding:

• Do you expect your tax bracket to be higher during your working years or in retirement? If higher today, tax-deductible contributions to pretax accounts can reduce your taxable income.
• Is a 401(k) available? Opting into a 401(k) is an easy way to save for retirement, especially with an employer match.
• Are you maxing out your retirement accounts? If so, consider a brokerage account for additional investments in stocks, bonds, ETFs, mutual funds, and more.

The Bottom Line

If you’re unsure whether to choose pretax or after-tax investing, consider exploring both options. This approach can help you grow your wealth in a tax-efficient manner, securing benefits today while preparing for a tax-friendly retirement.

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