After-Tax Accounts: An Important Piece of the Investment Puzzle Canandaigua National Bank & Trust

Whatever you decide, you're already planning and saving for retirement. Yes, remember that there costs to convert to a Roth 401, so time your conversion with a tax year chock full of deductions to offset those costs. And your earnings may be distributed tax-free, if you've met all of the necessary withdrawal qualifications.

• Your new set of rules can vary widely and could be more complex.
• The best news is that you don’t have to choose between traditional pre-tax and Roth savings option.
• Instead, taxes are paid on withdrawals, including any earnings.
• Each offers a different type of tax advantage, and choosing the right plan is one of the biggest questions workers have about their 401.
• Some savers, mostly those with higher incomes, may contribute after-tax income to a traditional account in addition to the maximum allowable pre-tax amount.

Because the traditional 401 gives you a tax break on contributions today, it can make sense to use that break today when your tax costs are high. Both the traditional 401 and the Roth 401 have required minimum distributions , but the Roth allows you to escape the RMD without any extra taxes.

What Is an After-Tax Contribution?

On the other hand, using an after-tax account now means you've already paid the tax on your contributions. For example, while brokerage accounts tax capital gains, Roth IRAs allow holdings to grow tax-free. As long as you withdraw from the account properly, you won't pay any taxes on capital gains or dividends acquired within the account. Not all of these investments are available in every pre-tax account. Employer-hosted pre-tax accounts, such as 401 plans, may limit the available investments to a pre-selected list of mutual funds. The pre-tax contributions, along with the earnings from both the pre-tax and the after-tax contributions, can be rolled to a traditional IRA, incurring no current income tax.

That is, the money is not subject to income tax in the year it is paid in. The saver's gross taxable income for that year is reduced by the amount of the contribution. The IRS will get its due when the account holder withdraws the money, presumably after retiring. When you make a pre-tax contribution, the money is invested before taxes have been applied to your paycheck. The immediate benefit is a larger contribution to your retirement account plus a lower taxable income.

What is a Roth 401(k), and how is it different than a traditional 401(k)?

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With a salary bump to $55,000, you would pay an estimated $9,488.75 instead. Assuming that you would need around $55,000 per year during retirement for comfortable living, it would make financial sense to pay income taxes on retirement savings earlier and put that money in a Roth 401. No minimum distribution requirements – Employer retirement plans and IRAs require account owners to take regular distributions starting at age 70-1/2, even if the money is not needed. The same is true, regardless of age, of inherited IRAs/Roth IRAs. Such distributions may elevate the taxpayer’s marginal tax rate and may also cause more Social Security benefits to be taxed.

Before-Tax Versus After-Tax Roth Contributions

The downstream impact occurs when you eventually withdraw the money – you must pay taxes on the amount contributed plus any growth that has occurred over the years you’ve saved. If you have a retirement plan that offers both pretax and Roth after-tax contributions, you have two ways to save for retirement.

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 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. A key benefit of a pre-tax retirement savings account is the potential to reduce your taxable income today, and not pay taxes until you withdraw your money. Instead, taxes are paid on withdrawals, including any earnings. Getting a tax break at the time of investment will leave more money in your pocket now — money that you can invest, save, or spend. For retirement planning, some financial planners will suggest a combination of pre-tax and after-tax accounts—using both a Roth IRA and Traditional IRA, for example. Having both is a method of tax diversification, helping you to hedge against a change in tax rates as well as a change in income in the future.

How to Decide: Pre-Tax vs. Roth

Your contributions can grow tax-deferred, and your paycheck will see less of an impact. After you’ve been in the DCP for a few years, consider adding after-tax contributions. These contributions help diversify your tax liability by giving you the choice of withdrawing from either your pre-tax savings or after-tax savings. You have two tax-advantaged ways to save in the DCP—Pre-tax and After-tax . Pre-tax contributions are made to your DCP account before taxes and are therefore deducted from your paycheck. After-tax contributions are made to your DCP account after taxes are deducted from your paycheck. The tax landscape changes frequently as rates, limits and thresholds adjust, and provisions are introduced or expire.

• In a traditional 401 plan, the earnings will be taxed when money is withdrawn from the account.
• If you want to take more than the minimum, consider the tax implications of which savings source you draw from—if you’re in a lower marginal tax rate, you can withdraw from your traditional account.
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• Income from selling a home that has increased in value may be sheltered up to a certain amount.
• As with everything in financial planning, it's important to weigh multiple inputs simultaneously.

After-tax contributions to your workplace plan can be withdrawn without taxes or penalties. Any earnings on those after-tax contributions are considered pre-tax balances—so taxes would have to be paid on withdrawals of the earnings and there may be a 10% penalty if you're under age 59½. The Charles Schwab Corporation provides a full range Difference Between Pre-Tax Vs. After-Tax Investments of brokerage, banking and financial advisory services through its operating subsidiaries. Its broker-dealer subsidiary, Charles Schwab & Co., Inc. , offers investment services and products, including Schwab brokerage accounts. Its banking subsidiary, Charles Schwab Bank, SSB , provides deposit and lending services and products.

Over time, this is a strategy you might consider to remove assets from your taxable estate. Review your assets to identify potential long-term capital gains , which are currently taxed at lower rates than short-term capital gains or ordinary income. After completing a Roth conversion within your workplace retirement plan, rolling out to IRAs should be relatively straightforward if you choose to do that. Roth IRAs have a 5-year aging requirement as well—if you’ve never contributed to a Roth IRA and roll in money from a Roth 401 another 5-year clock starts in January of the year in which the rollover was done.