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.
Pretax
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Taxes when withdrawn: Your contributions and any earnings are taxed.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 potentially 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.
After-tax
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Taxes when withdrawn: Your contributions are not taxed (remember, you've already paid taxes on them), but any earnings are taxed.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.
Roth
Like regular after-tax contributions, Roth contributions are deducted from your paycheck after taxes are taken out.
Taxes when withdrawn: Any earnings are not taxed if the withdrawal is considered qualified.
Benefit: Unlike regular after-tax contributions, you won’t pay taxes on any 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:
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You expect to be in the same or higher tax bracket as you are now during retirement.
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You don’t plan to take the money out for many years, which gives the amount you save today the potential to grow substantially by the time you need it.
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.
Example: How contributions may affect your paycheck
Name: Jane Participant
Salary: $2,500 every month (before taxes are taken out)
Savings rate: 6%
Jane’s paycheck if she saves pretax |
Jane’s paycheck if she saves after-tax or Roth |
The difference | |
---|---|---|---|
FOR ILLUSTRATIVE PURPOSES ONLY | |||
$ 1,998 | $ 1,975 | $23 | |
The difference | $23 |