One of the biggest questions we get and probably the biggest question in retirement investing is, should I invest in my 401(k) with pre-tax or post-tax money? And the follow up, what’s the difference?
Given that we are still in the beginning of the year, and the contribution limits for a 401(k) just got raised to $22,500 or $27,000 if you are 50 or over in 2023, we thought we could tackle this in this blog.
Let’s start with pre-tax contributions. This is contributions with money that hasn’t been taxed yet so your taxable income is reduced by the amount you contribute on a pre-tax basis. Meaning, if you make $50,000 per year, and you contribute $10,000 to your 401(k) pre-tax, you only pay income tax on $40,000 for the year. However, you do pay taxes on your contributions and the growth over the years in retirement when you use it for income.
Moving to post-tax. This is contributions made with money that has already been taxed. So, there is no tax benefit in the year that you contribute. If you make $50,000, and contribute $10,000 on a post-tax basis, you pay income tax on the whole $50,000. However, the benefit here is that your contributions will grow tax free. And even in retirement, both your contributions and the earnings over the years, can be withdrawn and used tax free in retirement.
Ultimately, it all boils down to the one thing we all want to know, which one is better? And the answer is, it depends. I know, anti-climatic. But it truly does depend. If you’re in a higher tax bracket now and you’re anticipating being in a lower tax bracket in retirement then pre-tax contributions might be a better fit. Because you get the tax benefit now and avoid paying a higher income tax on it, and later in life in retirement because your income isn’t as high, you’ll pay less tax then.
However, that goes both ways. If you’re in a lower tax bracket now, and when you retire you expect to be in a higher tax bracket, then post-tax contributions might be the better fit. You’ll pay a lower tax now, let it grow tax free and won’t have to pay taxes in retirement when you’re paying taxes at a higher rate.
Ultimately, everyone’s situation is different and there may be even more thought and factors that go into a decision like this. But, it is good to know your options and to take advantage of these options now to save and build the retirement that you want to.