There are three tax environments to be aware of; pre-tax, tax-free, and after tax.
A majority of retirement plans today offer employees the opportunity to save in a pre-tax environment. This allows the employee to defer a portion of their income, up to stated limits, into the company retirement plan. The income you defer into a retirement plan enters before it is taxed (also known as pre-tax contributions). Once in the plan, the money will grow tax-deferred so there are no tax concerns for you to address unless you take the money out early. Often your retirement plan has many different investment options for you to select based on the timing and first use. These plans are established to reward the long-term investor as you may begin to take your money out at age 59 ½. When you begin to withdraw those funds, you will pay federal and state income taxes at that time. A majority of clients who have been participating in “retirement investing” tend to have selected this pre-tax approach. Another benefit of pre-tax contributions includes a smaller W2 at tax time as your wages are lower. It’s also common for employers to provide a “company match” on your contributions into the retirement plan. This company match arrives in your pre-tax account overtime. Looking at a recent statement will allow you to determine how much you contributed from income and how much was contributed on your behalf by your employer.
A tax-free environment is also known as a Roth environment. There are Roth IRAs, Roth 401ks, and Roth Thrift Savings plans. When electing to invest in a Roth environment you pay taxes today, before the money enters the plan and is invested. It’s called “tax-free” but we all know that nothing in life is free! You are simply electing to pay taxes now, versus later, as was described in the above pre-tax example. When tomorrow arrives, and you “repurpose your time”, you are able to withdraw your Roth contributions and all the interest and earnings tax-free. Taking advantage of this tax-free income, as part of a written financial plan, allows greater flexibility and choices when it matters most.
This Roth environment is a relatively new offering compared to the pre-tax environment. There are some limitations when investing in a Roth environment. Roth IRA eligibility is limited based on income and tax filing status. Chances are, if you are reading this article, you’re likely unable to participate in a Roth IRA as you “earn too much”. Congratulations, high income earner! The good news is that Roth 401k and Roth Thrift Savings plans do not limit contributions or participation based on income. This allows all income earners to participate and utilize Roth 401k and Roth Thrift Savings plans. The news gets better, as those who switch employers have the ability to rollover their Roth retirement balances to a Roth IRA regardless of income level.
After-tax investing is the final tax environment to discuss. As it sounds, investments are made with after tax money already filtered through the tax system. This after-tax approach to investing does not have income limits so you may save as much as you would like. Taxes are paid annually, as capital gains are distributed in your investments. The type of investments you select, and how long you hold them, determines the amount of taxes due. For most, capital gains taxes tend to be less then income taxes. It’s this feature that offers a compelling environment to invest in when planning for income in the future.
So how do you determine what approach, or combination, is best when selecting the tax environment for your investments? More on that next time…
What is tax diversification? – Part 2
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