Understanding pre-tax and after-tax contributions for IRAs (Individual Retirement Accounts) can seem somewhat complicated if you don’t know the basics of the two types of IRAs: Traditional and Roth. The Traditional IRA is an individual savings plan that is tax-deferred – you don’t have to worry about paying taxes until you withdraw the money you’ve been contributing (penalty free after age 59 1/2). On the other hand, with a Roth IRA, your withdrawal will be tax free at retirement because you are paying taxes before you contribute to the plan. Pre-tax and after-tax contributions make a difference, because it can increase or decrease the amount you are investing with each contribution.
For some, having to pay taxes at withdrawal time works better because the possibility of them having a lower income at retirement age and being put in a lower tax bracket can essentially save them money. However, others would prefer not to have the burden of being taxed at all at the later date and thus choose the Roth IRA.
Here’s a quick example to see how either would work: Say you contribute the maximum allowable amount for one year of $5,000 to your traditional IRA. Because it is tax-deferred, you won’t be taxed on the amount you contribute initially. This means, down the road if you were to only contribute the $5,000 then attempted to withdraw it at the appropriate age (59 ½), that $5,000 would be taxed upon withdrawal as if it were income that you earned that year. If you suspect that your income will be lower in your retirement years, then you might feel that you can benefit from this plan. Meanwhile, if you contribute to a Roth IRA, you will be taxed one time for your contribution the year you contribute, and you won’t be taxed at all for the money you take out at the appropriate withdrawal time.
So the decision of which to choose comes with figuring out whether you would rather be taxed according to your current income, or the income you’re likely to have at retirement age. For some younger people, paying taxes now may be cheaper than paying later as their income is probably lower now, and their tax bracket is as well).
Because IRAs don’t allow for as large a contribution each year as a 401k, you may feel that being taxed now with the Roth IRA wouldn’t hurt, so just to get it out of the way. However, if you want to hold on to as much money as you can (and have as much money working for you as possible), then the Traditional IRA just might be the way to go.
Either way, if you’re looking to go with a traditional or Roth IRA, now is the time to make some important decisions so that you can decide which plan is ultimately best for you.