Retirement isn’t going to save for itself. It takes patience, planning, and for most people, a lot of research. During all this research, you’ve probably seen a host of jargon-filled articles mention the terms “pre-tax” and “after-tax” retirement accounts, often diving into them with no explanation of what they mean, and more importantly, how you can use them to your advantage.
In one of our previous blog posts, we explained what pre-tax contributions are and how and why you should utilize them to build your retirement savings. Now, it’s time to take a look at after-tax contributions.
Check out the video below from our Financial Edge Academy’s retirement module for a quick primer on everything you need to know about after-tax contributions, the type of accounts that allow for these contributions, and the various benefits they offer.
Many people are more familiar with pre-tax retirement savings accounts, like 401(k)s and traditional IRAs. But, how much do you know about after-tax retirement accounts, like Roth IRAs and Roth 401(k)s? Let’s take a closer look at how they work, when it might be beneficial to invest in one, and how to utilize them in your retirement savings strategy.
What Is an After-Tax Retirement Contribution?
Just like the name implies, an after-tax (or “post-tax”) contribution is any money put into a retirement account after deducting taxes from your taxable income. In general, any “Roth” account—like Roth IRAs and Roth 401(k)s—are post-tax retirement accounts. This means that you pay taxes on your contributions the same year you make them (like any other income you pay taxes on). But then when you take the money out during retirement, you don’t pay taxes. To put it simply, you’re paying Uncle Sam the taxes you owe on your retirement income upfront instead of later down the line.
Unlike pre-tax contributions, this is more of a direct hit to a person’s paycheck and taxable income. But again, after retirement, no further taxes are owed on the entire balance in the account. For example, say you’re retired and decide to start pulling $5,000 a year out of your Roth IRA. That’s income you don’t have to pay any taxes on; it’s all “post-tax” money you’ve already paid.
Making Roth Contributions Can Pay Off During the Early Stages Of Your Career
Are you in an entry-level position right now, but have big career ambitions for the future? If so, then a Roth account might be a good move during this stage in your life. That entry-level position you’re currently in may mean that you receive a lower paycheck, but it also means you’re in a lower tax bracket, so you might as well take advantage of it before you get that big promotion. If you can budget for those tax payments upfront, making Roth contributions would cost you less today and could result in tax savings during your golden years. Plus, you’ll be taking advantage of all that compound interest when you start your retirement contributions early on.
If your income increases to the point where you fall into a higher tax bracket, then switching your contribution strategy to a pre-tax retirement account may become the better option.
Benefits of After-Tax Accounts: Financial Flexibility During Retirement
A post-tax account gives you a lot of financial flexibility during retirement. With a Roth account, you can withdraw what you’ve put in—as well as interest earned—without paying any taxes (considering you’ve had the account for five years and are at least 59½ years of age). You can also continue to contribute to a Roth account as long as you live, which is a great way to continue growing your savings or leave a tax-free inheritance to your heirs (as long as you meet the income requirements).
But perhaps the biggest benefit is that there are no required minimum distribution requirements or RMDs. As the name implies, RMDs are the minimum the IRS requires you to take from your pre-tax accounts, usually starting after you turn age 72. If all your savings are in pre-tax accounts, you might face a hefty tax bill once it’s time to withdraw. Maybe you’ve budgeted ahead for this scenario, and it’s not a problem. But it can come as an unpleasant surprise to some retirees who didn’t remember to reroute those tax-deferred benefits into a savings account.
Because after-tax accounts aren’t subject to RMDs, you can use your savings when you need them, and at any given age—and you won’t face an unexpected tax bill when you dip into your funds.
Post-tax or Pre-tax Accounts? Why Not Try Both?
Pre-tax or post-tax accounts? A lot of people wonder which one is the better retirement vehicle for them. Is it better to pay your taxes upfront on those savings this year and enjoy a tax-free income during retirement? Or, is it better to defer payment on those taxes and make up those payments when you retire?
Unless you have a crystal ball that will show you what your income, tax rate, deductions, income, and expenses will be during retirement, there is not a clear-cut answer to this.
But, the good news is that you don’t have to choose between one or the other. You can split your contributions. Or, you can make an annual decision about which retirement account works better for you that year based on your tax bracket, overall budget, and other financial considerations.
Contributing to both a pre-tax and post-tax retirement account is one way to create a diversified retirement portfolio, give you financial flexibility, and hedge against an inaccurate prediction of a future tax rate that might work against you.
At TFNB, We're Here to Help You On Your Path Toward a Long, Happy Retirement
The bottom line? A post-tax retirement savings account is a great way to enjoy a tax-free income if you’re willing to pay upfront now. However, your situation is unique to you—just like your financial goals. At the end of the day, it’s a good idea to learn more about your retirement savings options to develop a strategy that’s right for you.
At TFNB, we pride ourselves on being your bank for every part of life—including retirement. If you have more questions about saving strategies, your 401(k), or your Roth IRA, our team is just a phone call (or a few blocks) away!