When you think about how to handle your money and plan for the future, it’s important to know about pre-tax and after-tax income.
These terms are important when you’re making decisions about saving for retirement, investing, and even budgeting for everyday expenses.
But which one is better: pre-tax or after-tax? Let’s look at both options to help you make smart choices with your money.
What Is Pre-Tax?
Pre-tax income is the money you earn before any deductions for taxes, retirement contributions, or other expenses are taken out. It’s your total earnings before the government takes its part.
What Is After-Tax?
After-tax income, also known as net income, is the money you receive after deductions like taxes and other withholdings. It’s the amount you can use for immediate expenses or optional spending.
Which Is Better for You?
Deciding if you should invest money before or after taxes depends on your own circumstances. Take a look at these factors:
1. Account For Investment Returns
Consider the anticipated profit rate on your investments when calculating the account for investment returns.
2. Understand How Taxes Are Applied
When you hold stocks for over a year, any profit you make is taxed at a lower rate compared to regular income, like the interest you earn on bonds. Understanding how different types of income are taxed can help you decide whether to invest with money that has already been taxed or before it has been taxed.
3. Calculate Returns After All Taxes Are Applied
If you withdraw money from a Roth IRA or Roth 401(K) after you turn 59.5 and have had the account for at least five years, you won’t have to pay any taxes. But if you withdraw money from a pretax investment, you will need to pay taxes on the amount you withdraw before you can calculate your actual return.
For example, if you withdraw $10,000 from a pretax investment and you are in a 25% tax rate during retirement, you will have $7,500 left after taxes.
If you invest money in a regular brokerage account without any tax advantages, you will need to pay taxes on the money before you invest it and on any earnings you make. However, when you withdraw money from a regular account, you usually won’t have to pay any additional taxes.
4. Compare Post-tax And After-tax
For instance, if you want to invest $10,000 in an account after paying taxes, and you are in a tax bracket of 25%, you will need to earn around $13,333 and pay $3,333 in taxes in order to have $10,000 to invest.
If you invest that $10,000 and it earns an annual interest rate of 5% for 10 years, it will be worth $16,289. Once you reach the age of 59.5 and if the account has been open for at least five years, you can withdraw all of the money without having to pay taxes on it.
Instead, imagine you put $13,333 into a savings account before paying taxes. The interest rate for this account is 5%. After 10 years, the total amount in the account will be $21,718.
If you decide to take out all the money and your tax rate is still 25% you will have to pay $5,429 in taxes. This means you will be left with the same amount of money, $16,289, as you would have if you had invested the money after paying taxes.
If, during the time in between, you have stopped working and your tax rate has gone down to 15% you will only have to pay around $3,258 when you withdraw the money from the account before taxes.
This means you will have about $18,641 left. In this situation, the money you invested before taxes will give you a higher profit after taxes are taken out.
If you are in the lower tax bracket when you invest and in a higher tax bracket when you retire, the opposite situation happens.
In this case, you would need around $11,765 to have $10,000 available for investment after paying taxes. Ultimately, you would end up with $16,289, which you can withdraw without having to pay taxes.
If you invest $11,765 before paying taxes at a 5% interest rate, you will have $19,164 after 10 years. This is a significant increase. However, if you withdraw that amount when you are in the 25% tax bracket, you will have to pay $4,791 in taxes, leaving you with only $14, 373.
In this situation, investing after paying taxes is better overall, as it results in approximately $1,916 more compared to investing before paying taxes. This difference is the gap between $14,373 from the pre-tax method and $16,289 from the after-tax approach.
Pros and Cons for Pre and After-Tax
Pros of Pre-Tax Income
1. Lower Current Tax Liability: Since taxes are not taken out right away, you receive more money in your paycheck, which can help with your immediate financial needs.
2. Tax-Deferred Savings: Putting money into accounts like a 401(K) or Traditional IRA before paying taxes can lower the amount of income you have to pay taxes on, which may decrease the amount of taxes you owe.
3. Employer Contributions: Employers give money to retirement accounts and it grows without taxes until it is taken out.Â
Cons Of Pre-Tax Income
1. Taxed Upon Withdrawal:Â Even though you get tax advantages when you put money in, you will have to pay taxes when you take it out during retirement. The amount of tax you’ll have to pay at that time is not known and might be more than what you currently pay.
2. Limited Flexibility:Â Money you put in before taxes usually has penalties if you take it out early or limits on how you can spend it before retirement.
Pros Of After-Tax Income
1. Predictable Tax Liability:Â It is easy to predict the amount of taxes you owe because they are already taken out, so it’s easier to plan your budget.
2. Flexibility:Â The money you have left after paying taxes can be used right away, so you can spend, invest, or save it without any limitations or extra charges.
Cons Of After-Tax Income
1. Missed Tax Benefits: You won’t get the advantages of tax deductions or deferrals that come with putting money into retirement accounts before taxes, which could mean you have to pay more in taxes right now.
2. Reduced Retirement Savings: Without the tax benefits of contributing before taxes, you may have a smaller amount of money saved for retirement.
In summary, deciding whether to use pre-tax or after-tax income involves weighing the benefits of current tax advantages against future tax obligations. It is important to think carefully and plan carefully in order to make the best choice for your financial future.
Thanks for reading. I hope you find it interesting.
