Pre or Post Tax Contributions

You’ll often hear the terms “pre-tax” and “post-tax contributions” when it comes to choosing between retirement plans. Traditional contributions to 401(k), 403(b), IRAs and other employer-sponsored retirement plans offer pre-tax contributions, whereas Roth contributions are made post-tax. So what is the difference and how do you choose between them?

With a pre-tax retirement account, contributions are deducted from your paycheck before taxes, thereby lowering your taxable income for the year. Any pre-tax earnings will grow on a “tax-deferred” basis, which means you’ll only pay taxes on earnings once you withdraw them from the account at retirement. At that point you’ll owe taxes based on your income at the time.

Post-tax Roth contributions, on the other hand, come out of your after-tax income (i.e. directly out of your pay check or checking account) and generally grow “tax-free”, meaning you will not pay taxes on qualified withdrawals at retirement age.

There are a couple of caveats here, though. First, both types of plans typically enforce a penalty on early withdrawals. With a few exceptions, any withdrawal that occurs prior to the age of 59 ½ will incur a 10% penalty tax regardless of your retirement plan. Roth accounts also have certain holding periods (typically five years) before you can make a “qualified” distribution without incurring a penalty.

Additionally, certain 401(k) and 403(b) plans do allow you to make additional after-tax contributions. Typically these are beneficial for individuals that want to make contributions that exceed the annual limit on pre-tax accounts (which in 2019 is $19,000 or $25,000 for those age 50 and older). These after-tax contributions can be rolled over into a Roth IRA after retirement, allowing them to grow tax-free.

So which type of contribution plan should you choose? The choice comes down to whether you think you would benefit from a tax break now versus in retirement. In other words: do you anticipate you’ll be in a higher tax bracket now versus when you retire? While perhaps an over-simplification, this is a general rule of thumb when deciding between pre- and post-tax contributions.

One other big thing to consider is whether or not your employer offers matching contributions to your retirement plan. Employer matching contributions are always pre-tax and amount to essentially “free” money. Therefore, the amount your employer matches can add up to a lot over time, potentially exceeding what you might save in post-tax earnings through a Roth IRA.

Ultimately, the best advice for choosing a retirement plan is to consult with an experienced professional. Depending on your income and tax situation, there may be ways to strategically allocate your retirement contributions between pre- and post-tax, or through specialized plans like Roth 401(k) accounts.

Talk to an Oppenheimer Financial Advisor today to learn whether a pre-tax or post-tax retirement plan (or both) is right for you.