When investing in a company retirement plan like a 401(k) or 403(b), many choices require careful consideration. One decision that may ultimately have the largest consequence is whether to save on a pre-tax or post-tax basis. Let’s explore how this choice could impact your tax situation now and in the future.
What’s the difference between pre-tax and post-tax? A pre-tax contribution is when the amount contributed to a retirement plan is deducted from gross wages (the overall total amount earned before taxes comes out). This will automatically drop your taxable income by the amount you contributed. Since you were afforded an upfront tax-break on your contributions, when you withdraw the money it will count 100% toward your taxable income. Conversely, the post-tax contribution option works in reverse. You start with your gross wages and make the contribution after taxes are withheld. Since taxes have been paid on the money today, the beauty of post-tax contributions in a retirement plan is that under current laws, you will be able to withdraw all of the money tax-free under certain provisions. Take the following example. Assume you make $50,000 per year, are in the 20% tax bracket, and contribute 5% to a retirement plan.
As the hypothetical example depicts, one would think using the pre-tax option fairs better as $2,500 would be saved opposed to $2,000 in post-tax savings. The most important thing to understand is the difference in how money will be withdrawn during retirement. The IRS understands they’ve allowed a pre-tax contribution lowering our taxable income for the year, but eventually they will expect their share. This is where the decision between pre-tax versus post-tax becomes paramount. Had one saved on a post-tax basis, when executed properly all withdrawals can be tax free. The question to ask is, “Do I think taxes will be higher in retirement?”
Let’s continue from our previous hypothetical. Assume the contributions are invested annually for 25 years and average a 7% rate of return. At the end of the term you would expect:
If you save on a pre-tax basis you’ve ultimately deferred paying taxes until you retire. From the post-tax example, you paid taxes along the way to ultimately have a tax-free retirement “bucket” of money. Either way you cut it, based on this example you end up in the same place. It’s apparent this example is generic by design and chances are for your specific situation no clear-cut solution may exist. You must ask yourself the following questions when deciding between pre-tax or post-tax contributions:
Do I think taxes will go up or down?
What if I defer taxes now to only end up in a higher tax bracket later?
How will I manage the fact that the IRS requires mandatory withdrawals from pre-tax accounts?
Am I confident I will withdraw my nest egg efficiently? Especially given that taxable income can impact how Social Security is taxed?
As always, our team of financial planners and tax professionals are here to answer these questions or help you chart the best course with your pre-tax or post-tax retirement contribution decisions.
Call us today for a complimentary review of your financial situation.
Strategic Tax and Retirement
2434 Superior Drive NW, Ste 101
Rochester, MN 55901
Securities offered through Peak Brokerage Services, LLC, Member FINRA/SIPC . Advisory Services offered through STAR Capital, INC., a Registered Investment Advisor. Strategic Tax and Retirement and STAR Capital are not affiliated with Peak Brokerage Services.