In talking about different types of savings accounts and investments, we frequently use the terms pre-tax, after-tax, tax-deferred, and tax-free. Let's take a look at what they mean and how they relate to 401(k) investing.
Pre-tax money means income you receive that you have not paid income tax on. It doesn't necessarily mean you will never have to pay tax on those dollars. For example, you contribute pre-tax dollars to your 401(k) plan, but you will eventually pay tax on those dollars when you withdraw the money from the plan. Over time, this tax deferral turns into big savings. Here's an example.
Let's assume you earn $40,000 and contribute 5% to your 401(k) plan. Your annual contribution would be $2,000 ($40,000 times 5%.) Let's also assume you're in the 25% tax bracket. Your annual tax deferral would be $500 ($2,000 times 25%.) Over time, here's how your tax deferral of $500 each year will grow assuming an annual pretax rate of return of 8%:
Remember, this chart shows only the savings attributable to an annual tax deferral of $500 and how it can grow over the years. These amounts do not include your $2,000 annual contribution, nor its growth over time through investments.
When you withdraw pretax contributions from your 401(k) plan, you must pay ordinary income tax on the amount withdrawn. Also, if you take a withdrawal before age 59½ (or age 55 if you retire at that age), you may be subject to a 10% penalty. For more information, see the section Your 401(k) When Switching Jobs.
After-tax money is money on which you have already paid income taxes. Some 401(k) plans allow you to contribute after-tax money to the plan, although some plans only allow this after you have made the maximum permitted pre-tax contribution. If you can save more than the yearly pre-tax dollar limit, you should consider putting after-tax dollars in the 401(k) once you have saved the maximum in either a Roth or a traditional IRA. While you don't save any current taxes on the after-tax contributions, the money earned by your after-tax contributions will not be taxable until you take the money out of the plan. This will make your savings grow faster.
IMPORTANT NOTE: Some plans contain a company match. If yours does, you need to determine if the company match will outweigh the benefits afforded by a Roth IRA.
After-tax contributions are more liquid than pre-tax contributions. If you need to withdraw this money, you will be subject to ordinary income tax only on the earnings, not the after-tax contribution, since you already paid income tax on the money before you put it into the 401(k) plan. But remember, the 10% penalty may apply to the earnings if you take a withdrawal before age 59½ or prior to retirement at age 55.
Remember that with after-tax contributions to a 401(k) plan, you are not getting the benefit of a tax deferral like you are with pre-tax contributions. So you can see that it makes lots of sense to contribute the maximum pre-tax contributions before making after-tax contributions.
When we use the term tax-deferred, it simply means that the earnings on the money invested is not taxed until some later date. In a traditional 401(k) plan, the earnings will be taxed when money is withdrawn from the account. This is an important feature, because it allows your money to grow more quickly than if it were invested in a taxable investment. Taxes on your pre-tax contributions are also deferred until you withdraw the money from the account.
When you take a qualified distribution from a Roth IRA, it will not be subject to tax provided you have met the age and holding period requirements. Neither the contributions nor the earnings will be taxed. This feature will allow your money to grow much more quickly than if it was invested in a taxable account.
SUGGESTION: Whenever you think about your long-term savings, think tax-free and tax-deferred. While you may eventually have to pay taxes on your savings and future earnings, you are taking advantage of tax-deferred compounding. Saving on a tax-free basis means you will never have to pay taxes on your savings and earnings. As an example, $100 in a tax-free Roth IRA grows to $761 on a tax-free basis in 30 years, assuming a 7% rate of return. In a tax-deferred account, assuming you're in the 25% tax bracket in 30 years when you withdraw the money, you will have $571, vs. $428 in a taxable account.
NOTE: The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 1/2 may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change. Before making a Roth IRA withdrawal, keep in mind the following guidelines, to avoid a potential 10% early withdrawal penalty:
• Withdrawals must be taken after age 59½.• Withdrawals must be taken after a five-year holding period.• There are exceptions to the early withdrawal penalty, such as a first-time home purchase, college expenses, and birth or adoption expenses.