What Do ‘Pre-Tax’ and ‘Post-Tax’ Mean? And Why Should I Care?

Almost every article you read about retirement savings brings up the terms “pre-tax” and “post-tax” savings, often throwing the ideas out there with no real explanation of what they mean or why they’re important. I know that the first time I encountered those terms, I was pretty unclear as to what the big deal was, too, or even why I should care at all.

So let’s start from the beginning and work through what those terms mean and why they really should matter to you as you think about saving for retirement.

Most people have a few options out there for saving for retirement. You can, of course, save your money in an ordinary savings account if you’d like, but doing that means that there’s no extra benefit in terms of your taxes.

Some people have access to a retirement plan through work, often called a 401(k) or a 403(b) (if they work for a nonprofit) or TSP (if they work for the government) – there are a few other similar plans. Outside of that, people who want to save for retirement have the option to open a traditional IRA.

All of those plans have a few things in common.

First of all, when you put money in there, you do not have to pay income taxes on that money that year. Let’s say you make $50,000 this year and you decide to put $5,000 into your 401(k). Rather than paying income taxes on $50,000, you’ll only have to pay it on $45,000 of your income. This is why, when you put money into this plan, it’s called “pre-tax” money – it comes out of your pay before taxes are calculated.

“Big deal,” you say? Well, let’s say you’re a single person making $50,000 a year. If you don’t contribute to your 401(k) plan at all, you’re going to owe $5,719 in federal income taxes. However, if you contribute $5,000, you’ll only owe $4,744 in federal income taxes.

That’s right, contributing to a “pre-tax” retirement account actually cuts down on the amount you owe. For most people, the effect of this is that, although each of their paychecks will be leaner because of the contributions, it won’t be that much leaner. While some of your pay is in fact going into the 401(k), you also have less going away into taxes, so it means your take-home pay will go down a little, just not as much as your contribution.

That’s the core idea behind “pre-tax” contributions – you don’t have to pay taxes when you put in the money. However, you do have to pay taxes when the money comes out of those accounts when you’re of retirement age. At that point, your 401(k) kind of acts like your employer does now – when you withdraw money from it, it’ll be like a paycheck today in which taxes are taken out before you’re “paid.”

So, what about “post-tax” contributions? In general, that’s what the word “Roth” indicates on retirement accounts. Roth IRAs, Roth 401(k)s – you put your “post-tax” money into those accounts, meaning that it comes out of your paycheck after taxes are collected or, in the case of a Roth IRA, straight out of your checking account. Your taxes don’t go down at all this year.

So why would anyone ever do that? Well, the big benefit of a Roth account is that you don’t have to pay any taxes when you take the money out when you reach retirement age, not even on the investment gains your money earned while in the account. It’s all tax-free at that point.

So, let’s say you’re retired and decide to start pulling $5,000 a year out of your Roth IRA. That’s money that you don’t have to pay any taxes on – it’s all “post-tax” money.

As you can see, both of these approaches offer some benefit over simply putting money in a savings account. If you’re funding a “pre-tax” retirement account – your 401(k) or 403(b) at work or a traditional IRA – then you don’t have to pay any taxes right now on the money you put in, which means your taxes for this year go down. On the other hand, if you contribute to a Roth IRA or a Roth 401(k), you don’t have to pay taxes later on when the money comes out of the account, meaning your taxes for that future year go down.

A savings account, on the other hand, is funded with post-tax money, which doesn’t help you this year, and you have to pay taxes on any interest that you gain along the way.

Now, both IRAs and 401(k) accounts have some restrictions on withdrawals, the big one being that your withdrawal options are very limited until you hit a retirement age of 59 1/2 (or can provide clear proof that you’ve retired earlier than that), at which point there are almost no restrictions on withdrawals. In other words, if you’re actually saving for retirement and use the account for that purpose, it’s not a big deal.

So, now the big question becomes whether it makes more sense to invest your money in a “pre-tax” retirement account or a “post-tax” account. Is it better to pay your taxes on that money this year and then have tax-free income in retirement? Or is it better to reduce your taxes this year but have to pay taxes on that money when you retire?

The honest truth is… I don’t know. That’s because there’s one giant unknown that reigns over everything: We don’t have any idea what tax brackets will look like in the future. No one really knows what the tax rates will be in the future for anyone. Will they be higher? Will they be lower? Will they be lower for low-income people and higher for high-income people? It’s honestly impossible to predict.

The only idea I feel pretty confident about is this: The lower your income is in retirement, the lower your tax rate will be. The United States has used a progressive tax system since they started doing income taxes. A progressive tax system simply means that the less income you have, the lower your percentage tax rate is. While it may become less progressive (meaning the tax rates between poor and rich become closer together) or more progressive (meaning that the rates become further apart or that there’s a much higher cutoff before people have to start paying taxes), I think it will still remain true that a higher income means a higher tax rate.

Given that idea, I can make a few general recommendations that, while probably not perfect, are very likely to get you in the right account.

To put it all in a nutshell, the higher your salary is, the better a “post-tax” retirement plan looks. That’s because the higher your salary is, the higher your taxes are going to be this year and the less likely that your tax rate in retirement will be even higher.

In short, if your salary is an entry-level salary or one that you realistically expect to get much higher later in your career, a Roth IRA or a Roth 401(k) is better for you right now. That’s because you’re already paying a low tax rate today, so you might as well take advantage of that. Sure, you might find out in retirement that your tax rate is even lower, but it can’t be much lower and it certainly can be much higher.

On the other hand, if your salary is pretty strong and you don’t anticipate enormous jumps in salary in the future, contributing to a normal 401(k)/403(b) or a traditional IRA is probably better for you. That’s because you’re paying a high tax rate today, so you’re going to want to reduce your taxable income today. Sure, you might find out in retirement that your tax rate is even higher, but it probably won’t be much higher and it certainly can be much lower.

There’s one minor factor that trumps all of this, though: employer contributions. If your employer is matching your contributions to one of your retirement savings accounts, the value of that extra employer contribution money is going to blow away any tax benefits. It’s not even close. So, if employer contributions are on the table, ignore all of this and chase those contributions. They’re going to be worth more than the tax benefits even in the craziest of situations.

So, here’s the take-home message: If your income is low and you expect it to go much higher, use a Roth. Otherwise, use a 401(k) or 403(b). Above either option, though, is employer contributions – do what you have to do in order to get all of those contributions. Follow that simple recipe and you’ll make a very good choice for retirement.

Related Articles:

Loading Disqus Comments ...
Loading Facebook Comments ...