Pretax vs. After Tax vs. Roth – What’s Best for Your Retirement?

Tax diversification plays a key role in retiring successfully and staying successfully retired.  Investors who embrace this approach while accumulating their wealth will have more choices at retirement.  A challenge all investors face is the ever-changing tax landscape.  The current code is scheduled to reset December 31, 2025, which means a return of higher brackets for most taxpayers.  Knowing this, how may tax diversification influence where you invest today?

When investing, it makes sense to diversify where your monies go.  Selecting different size companies, industries, and locations is a good start.  This same approach to diversification may also be applied to where your investments live.  Pretax, after tax, and tax free environments.

Pretax:

All retirement plans offer employees the opportunity to save in a pretax environment.  An employee’s income enters a retirement plan before it is taxed which reduces their W2 income.  Once in the plan, monies may be invested and will grow tax deferred each year.  Income taxes are collected when dollars are distributed through retirement.

After tax:

Many large employers offer after tax retirement contributions.  Available to all, though mostly used by high income employees who invest beyond regular retirement contributions.  This allows for significant added deferrals IF an employee’s spending and lifestyle choices make it possible.  Often these after-tax retirement contributions are converted to Roth contributions inside the employer plan automatically.

Another after tax approach includes selecting investments outside of a retirement plan.  Examples include purchasing stock, exchanged traded funds (EFTs), or mutual funds in a personal investment account.  No limits on contributions and the flexibility to liquidate investments without penalty prior to retirement.  An investor’s income determines the long-term capital gains tax which may be 0%, 15%, or 20% which is applied to any gains.

Tax free:

A tax free environment is also known as a Roth environment.  There is nothing “free” about taxes, here employees are paying income taxes today before monies are contributed to their Roth retirement account. Contributions grow tax deferred and at retirement (after age 59 ½), tax free income is received assuming the Roth IRA has been open for five years.

So, which environment is best to when planning for your retirement?  Before answering, consider the following:

• How long do you or your spouse plan to work?
• Do you expect being in a lower tax bracket tomorrow or might it be higher?
• How does the taxation of social security benefits and perhaps a pension impact future income?

Integrating your answers into a financial plan that is revisited each year to reflect change may help determine your possibilities.  Each family has different priorities and goals, though most agree that flexibility of choices is super important when it comes to financial matters.  Here’s how our family approaches tax diversification.

I’m deferring income to my company’s Roth 401k.  The employer match arrives in pretax dollars but that will be changing to Roth when possible as we covered last week.

Why Roth 401k?  First, I believe taxes are lower today then they will be tomorrow.  Second, I already have pretax dollars in an IRA from a prior employer.  Deferring to Roth for the next twenty years or so will supply more planning options.  Third, Social Security is taxable as is the pension I will receive from my former employer.  Both increase our family tax bracket before a dollar is removed from our pretax accounts.

In addition to the 401k, we continue to invest in our after tax investment account and 529 plans via automated monthly contributions.  This approach allows us to build wealth while leaving room for errors and opportunities should our plans change.  It also allows us to spend the rest as we choose without feeling guilty.  This last sentence is worth re-reading.

Change is constant and plans need updates.  Investors with patience, flexibility, and a good temperament will be rewarded.  Integrating tax diversification in our investments provides our family more choices.  This approach may work for your family too!

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