There can be tax-related benefits for saving through your retirement account. The question is this: Do you want to take advantage now or later?
Depending on the choices your plan offers, there are generally three ways to contribute to your account.
Contributions to your retirement account are deducted from your paycheck before taxes are taken out.
Taxes when withdrawn: Your contributions and any earnings are taxed.
Benefit: Your money grows tax-deferred. Instead of paying taxes on your money now, you pay them later, most likely in retirement when you may be in a lower tax deferred bracket. This means that you can take advantage of extra take-home pay now AND potentially pay taxes later at a lower rate.
Contributions are deducted from your paycheck after taxes are taken out.
Taxes when withdrawn: Your contributions are not taxed (remember, you've already paid taxes on them), but any earnings are taxed.
Benefit: If you're in the same or higher tax bracket during retirement, you will pay taxes only on the earnings rather than on the entire amount of the distribution. This could appeal to you if you want to save above the annual pretax/Roth limits for your retirement plan.
Like regular after-tax contributions, Roth 401(k) contributions are deducted from your paycheck after taxes are taken out.
Taxes when withdrawn: Your earnings are not taxed if the withdrawal is considered qualified.
Benefit: Unlike regular after-tax contributions, you won’t pay taxes on your earnings when you make a qualified withdrawal. To get the tax benefit, the contributions must have been in your account for at least five years, and the withdrawal must be made after age 59½, death or a disability.
This may be a good option if:
The most important thing is that you save as much as you can for your future regardless of which contribution option you choose. And you don’t have to choose just one. One way to maximize and diversify your savings may be to contribute both pretax and after-tax dollars.
if she saves pretax
|Jane’s paycheck if
she saves after-tax or Roth
|$ 1,998||$ 1,975|
Assumes a $30,000 annual salary and a 15% federal, state and local tax rate. For illustrative purposes only. Taxes on savings are deferred until withdrawal. Pretax deferrals do not lower your income for FICA and FUTA tax-withholding purposes.
This material has been prepared for informational and educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.