The Benefits of Pre-Tax Retirement Accounts
Have you noticed the terms “pre-tax” and “post-tax” when looking at your retirement accounts? If you’re confused about what these terms mean, learn the difference between them to help maximize your tax savings.
One way or another, each dollar you earn as income usually runs through the tax system. The type of retirement account you set up determines whether this happens right away or years in the future. Here’s the big question: Is it better for you to pay taxes now or later? Let’s take a closer look at pre-tax contributions to help you answer this question.
What is a Pre-Tax Retirement Account?
“Pre-tax” means before paying taxes and usually refers to contributions made to a tax-deferred retirement account. These include:
- Traditional individual retirement account (IRA)
- Deferred compensation plan
Pre-tax contributions deposit directly into your retirement account. The money is not taxed as long as it remains in that account. This means your dividends, interest, and capital gains grow on a tax-deferred basis until you withdraw them.
Benefits of Pre-Tax Retirement Accounts
Many people choose to make pre-tax contributions because of these great benefits:
Pre-tax contributions save you money today by reducing your taxable income.
Pre-tax contributions are invested in stocks and bonds that pay dividends or interest each year. Being in a tax-deferred account means you don’t pay taxes on this growth. The compounding effect of these reinvested amounts can really snowball into amazing results by the time you withdraw the money after retirement.
When you make a withdrawal from a pre-tax retirement account, the money finally runs through the tax system. This is when you pay taxes on your retirement account contributions. Most retirees are in a lower tax bracket than when they were working. As a result, you will probably pay fewer taxes in the end than if you had opened a post-tax retirement account.
When to Consider Post-Tax Contributions
Pre-tax retirement accounts aren’t for everyone. That’s why the IRS also offers post-tax contributions. “Post-tax” is when you pay taxes right away, leaving you with tax-exempt retirement income. Consider setting up a Roth 401(k) or Roth IRA if:
You’re in a low tax bracket now and expect to be in a higher bracket later due to retirement income or because you think taxes will increase.
You would rather have your income run through the tax system now instead of at retirement so your nest egg isn’t subject to further taxation.
If you still have questions about pre-tax vs. post-tax retirement accounts, Nelson Financial Planning can help you decide which option is best for you. Our team consists of Certified Financial Planners who fulfill their fiduciary duty to keep your best interests in mind at all times. With our help, you’ll understand the rules better than ever so you can maximize your tax savings. Contact us today at 407-629-6477 to schedule your free initial consultation.