Pre-Tax vs. After-Tax Investments

You may hear the terms “pre-tax” or “after-tax” concerning investment accounts when you're discussing retirement plans. Knowing the difference between the two can help you maximize your dollars and minimize your tax burden. Here's how to tell the difference, and how to use both to your advantage.

What's the Difference Between Pre-Tax and After-Tax Accounts?

With a pre-tax account, you or your employer put money into a retirement account before taxes are assessed with a pre-tax account. These are also known as "tax-deferred" accounts because you defer paying taxes on the money you contribute until you withdraw from the account in the future.

With an after-tax account, you earn the money, pay income tax on it, then deposit it so it can earn interest and grow. The original amount you invest is called the "principal." This is also known as your "cost basis" in a taxable investment account. You only pay tax on any investment gain above your original investment amount when you cash in an after-tax (non-retirement account) investment.

Not all gains within after-tax accounts are taxed the same. The longer you hold an investment, the more favorable your tax situation generally becomes. Long-term investments deliver returns in the form of qualified dividends and long-term capital gains, and these types of investment income are subject to a lower tax rate in many cases. Sometimes long-term capital gains aren't taxed at all.

You'll receive a 1099-DIV, 1099-INT, or 1099-B form from your financial institution each year if you hold money in an after-tax account. The form will show you any interest income, dividend income, and capital gains you earned for that year. This income must be reported on your tax return.

Examples of Pre-Tax Accounts

Your pre-tax contributions lower your taxable income by the amount deposited. For example, your reported taxable income for the year would be $38,000 if your taxable income was going to be $40,000 for a given year and you put $2,000 of it in a pre-tax account such as a traditional IRA. The Internal Revenue Service (IRS) caps the amount you can deposit into these pre-tax vehicles each year, and it varies by account as well as by your age.

Not only do pre-tax contributions lower your taxable income for that year, but you don't have to pay tax on the interest income, dividend income, or capital gains until you make a withdrawal. Deferring your taxes in this way gives your principal time to grow and accrue interest.

The downside of pre-tax accounts is that you don't get to take advantage of the lower tax rates that apply to qualified dividends and long-term capital gains. Investment income inside of pre-tax accounts is all taxed the same way: as ordinary income upon withdrawal.

A pre-tax retirement account must have a custodian, or financial institution, whose job it is to report to the IRS the total amount of contributions and withdrawals for the account each year. The custodian who holds your pre-tax account will send you and the IRS a 1099-R tax form in any year that you make a withdrawal. A penalty may also apply if you take a withdrawal from a pre-tax account early (typically, before age 59 1/2). This penalty is generally 10%.

Pre-tax accounts include:

• Traditional IRAs
• 401(k) plans
• Pensions
• Profit-sharing accounts
• 457 plans
• 403(b) plans

You may be able to choose from many different types of investments within these accounts, such as:

• CDs
• Annuities (fixed, variable, or immediate)
• Mutual funds
• Stocks
• Bonds

Examples of After-Tax Accounts

Most retirement accounts are pre-tax accounts. You get a tax break upfront for saving. But Roth IRAs are an exception.

These accounts are funded with after-tax dollars, but they offer significant tax benefits to those who wait until retirement to withdraw from them. Roth IRAs allow holdings to grow tax-free while brokerage accounts tax capital gains. You won't pay any taxes on capital gains or dividends acquired within the account as long as you withdraw from the account properly.

Examples of these types of accounts include:

• Savings accounts
• Certificates of Deposit
• Money-market accounts
• Regular, taxable brokerage accounts (where you can buy just about any investment, such as mutual funds, stocks, bonds, or annuities)
• Roth IRAs

A Best-of-Both Worlds Option

Some financial planners suggest a combination of pre-tax and after-tax accounts for retirement planning, using both a Roth IRA and a traditional IRA. Having both is a method of tax diversification. It can help you to hedge against a change in tax rates as well as a change in income in the future.

Contributing to a pre-tax account now may mean that your investment and earnings will be taxed at a lower rate later, in your retirement years. But using an after-tax account now means you've already paid the tax on your contributions.

Of course, these financial guidelines are quite general, and your personal financial profile must be taken into account. Speak to your financial planner about the ideal way to structure your accounts.

Frequently Asked Questions (FAQs)