To maximize your investments, it’s essential to understand the meanings of pre-tax and post-tax dollars and how each affects your investments. Understanding each type of investment account will help you maximize your investment and ease your tax load.
Also known as “tax-deferred accounts,” pre-tax accounts are retirement vehicles in which funds are invested before taxes are assessed. This means you defer paying taxes until you withdraw the funds from the account in the future. The thought behind pre-tax accounts is that you will likely be at a lower tax bracket when you withdraw the funds, so you enjoy more favorable tax rates than you would during your prime earning years.
Pre-tax accounts include:
- Traditional IRAs
- 401(k) plans
- Profit-sharing accounts
- 457 plans
- 403(b) plans
Within pre-tax accounts, there are different types of investments to choose from:
- Annuities (fixed, variable, or immediate)
- Mutual funds
Pros and cons of pre-tax accounts
Besides deferring taxes on these investments, you are also able to lower your taxable income by investing in pre-tax accounts. For example, let’s say your taxable income would be $100,000 for a given year. But, you invested $15,000 in a pre-tax account such as a traditional IRA. This lowers your reported taxable income to $85,000 for that year. In addition, you do not have to pay taxes on interest, dividend, or capital gains income until you withdraw the funds. The deferral of your taxes in this way allows your principal to grow and earn interest.
In contrast, pre-tax accounts have the disadvantage of not taking advantage of lower taxes applied to qualified dividends and long-term capital gains. Withdrawals from pre-tax accounts are all taxed as ordinary income.
With after-tax investments, you pay income tax on what you earned and deposit it into an account where it can earn interest.
After-tax accounts include:
- Roth IRAs
- Savings accounts
- Money-market accounts
- Regular, taxable brokerage accounts (such as mutual funds, stocks, bonds, or annuities)
A taxable investment account’s “principal” is also known as its “cost basis,” so you pay tax only on the investment gain over your original investment amount when you cash in an after-tax investment (non-retirement account).
Despite this, not all gains are taxed the same within an after-tax account. Generally, the longer the investment sits, the better your tax situation. Long-term investments provide returns as qualified dividends and long-term capital gains, which are taxed at a lower rate.
For portfolio diversification, it’s often recommended to invest in a mix of pre-tax and after-tax accounts. Doing so can help you hedge against future changes in tax rates and income levels.
Investing in a pre-tax account now may make your retirement years more tax-efficient since you will pay a lower tax rate on your earnings and investments later. In contrast, using an after-tax account means you’ve already paid taxes on your contributions.
In truth, there is no one right formula for everyone. People have different goals and life circumstances. At Hiley Hunt, we work with you to create an investment strategy that maximizes your investments to meet your goals. Contact us to start planning your financial future today.