What Is Pretax Investing?

Pretax investments, also known as tax-deferred investments, are funded with money that hasn’t been taxed yet. For example, contributions to a 401(k) are typically made through automatic payroll deductions from your gross pay, reducing your taxable income and lowering your tax liability.

While pretax investing can help you keep more money in your pocket during your working years, you will owe taxes when you withdraw funds from these accounts. One exception is withdrawals from a health savings account (HSA) used for qualified medical expenses, which are tax-free.

Pros of Pretax Investing

• Contributions are generally tax-deductible, reducing your taxable income during your working years.
• Employer-sponsored accounts like 401(k)s may offer an employer match.

Cons of Pretax Investing

• Withdrawals in retirement will be taxed as ordinary income.
• Taking out too much could push you into a higher tax bracket.
• Early withdrawals before age 59½ may trigger a 10% penalty.
• Required minimum distributions (RMDs) apply to tax-deferred accounts starting at age 73.

Examples of Pretax Accounts

• 401(k)
• 403(b)
• 457 plan
• Traditional individual retirement account (IRA)
• Health savings account (HSA)
• 529 savings plan

What Is After-Tax Investing?

After-tax investments are funded with money that has already been taxed. For instance, if you invest through a brokerage account or Roth IRA, you are using after-tax dollars. The main advantage of after-tax investing is that it can provide tax- and penalty-free retirement income.

For example, Roth IRA contributions can be tapped at any time without taxes or penalties. However, you may be taxed on investment earnings if you’ve had the account for less than five years and are under 59½.

Pros of After-Tax Investing

• After-tax investments can be a great source of retirement income as they generally don’t trigger a tax bill.
• Roth IRAs offer tax-exempt growth, meaning you won’t pay taxes on dividends or capital gains.
• Brokerage accounts have no contribution limits or withdrawal penalties, though investment gains are taxable.

Cons of After-Tax Investing

• Contributions are not tax-deductible.
• IRAs have lower contribution limits compared to 401(k)s.
• Roth IRAs are not available through employers, though some offer a Roth 401(k) option with an employer match.

Examples of After-Tax Accounts

• Roth IRA
• Roth 401(k)
• Brokerage account
• Certificate of deposit (CD)
• Money market account
• Savings account

How to Choose Between Pretax and After-Tax Investments

The goal is to strike a balance between the two. If all your nest egg is in pretax accounts, every withdrawal in retirement will be taxable, potentially creating a significant expense. Conversely, saving strictly in after-tax investments could mean missing out on tax perks and employer contributions during your working years.

Having a mix of pretax and after-tax investments can help you secure tax benefits today while shielding you from hefty tax bills in retirement. Consider the following factors when deciding what’s best for you:

• Do you expect your tax bracket to be higher during your working years or in retirement? If your income is higher today, tax-deductible contributions to pretax accounts could reduce your taxable income.
• Is a 401(k) available to you? If so, opting in is an easy way to save for retirement, especially with an employer match.
• Are you maxing out your retirement accounts? If you’ve contributed the maximum to your 401(k) and IRAs, consider a brokerage account for additional investments.

The Bottom Line

If you’re torn between pretax and after-tax investing, consider exploring both options. This approach can help you grow your wealth in the most tax-efficient way, securing tax benefits today while setting yourself up for a tax-friendly retirement.

At O1ne Mortgage, we understand the importance of making informed financial decisions. Whether you’re looking to invest in pretax or after-tax accounts, our team of experts is here to help. Call us at 213-732-3074 for any mortgage service needs. Let us guide you towards a financially secure future.