When discussing retirement plans and taxes we often use the terms “pre-tax” or “after-tax” dollars. How do you know what is pre-tax and what is after-tax?
After tax dollars are pretty easy to understand. If you earn the money, pay income tax on it, and then deposit it into some type of account, or buy an investment with it, it is after-tax dollars.
The original amount you invest is called your cost basis, or principal. When you cash-in an after-tax investment account, you only pay tax on any investment gain above and beyond your original investment amount.
When you have funds in an after-tax account you will receive a 1099 tax form from your financial institution each year. This 1099 form will show you the interest income, dividend income and/or capital gain earned for that year, which must be reported on your tax return.
After tax dollars can be invested in just about anything: CD’s, savings accounts, mutual funds, stocks, bonds, real estate, annuities and much more.Learn more about taxation and after-tax accounts:
Pre-tax dollars are held inside of accounts such as IRAs, 401k plans, or other retirement plans like pensions, profit sharing accounts, 457 plans or 403b plans.
It is required that a pre-tax account have a custodian. It is the custodian’s job to report to the IRS the total amount of contributions and withdrawals that are made to pre-tax accounts.
The IRS rules allow you and/or your employer to put a designated amount into these pre-tax accounts each year and not pay income tax on the amount contributed. (If your taxable income was going to be $40,000 and you put $2,000 in a pre-tax account like a deductible IRA, then your taxable income for that year would only be $38,000.)
The funds inside of such pre-tax accounts grow tax-deferred, so you do not get a 1099 tax form each year, and you do not have to pay tax on the interest income, dividend income and/or capital gain earned inside of such pre-tax accounts.
At such time as you take a withdrawal from a pre-tax account, the entire withdrawal will be taxable income in the calendar year you take it. The custodian, or financial institution, that holds your pre-tax account will send you and the IRS a 1099-R tax form in any year that you take a withdrawal.
Within a pre-tax account you can buy numerous types of investments such as CD’s, annuities (fixed, variable or immediate), mutual funds, stocks, and bonds.Learn more about pre-tax accounts:
You can also have accounts that have a combination of pre-tax and after-tax dollars. They are called tax-deferred accounts.
Tax deferred accounts are funded with after-tax dollars, but once funded, just like with pre-tax accounts, you do not have to pay tax on the interest income, dividend income and/or capital gain earned until such time as you take a withdrawal.
The most common type of tax deferred savings are fixed and variable annuities, non-deductible IRA accounts, and cash value life insurance.Learn more about tax deferred accounts: