How will my Retirement accounts be taxed? Pre-tax vs. ROTH
This week we are going to drill down on common retirement accounts – what types of accounts are these? When do I contribute to one versus the other? What are the tax advantages and disadvantages?
These topics will be broken up into two blog posts, today we will cover pre-tax accounts, and next week we will review ROTH accounts (in addition to Health Savings Accounts – HSA).
Let’s begin.
Pre-Tax Accounts (Traditional IRA & 401k)
While traditional IRA’s and 401ks act very similar from a tax perspective, they do differ with contribution limits – IRA’s have a maximum contribution of $8,000 (over age 50 & $7,000 under age 50) for 2024, 401ks maximum contribution is $30,500 (over age 50) & $23,000 (under age 50). Furthermore, if you have a retirement plan at work, there are income phase out limits for IRA contributions – we will not cover these today, but this is something to be aware of.
In a nutshell, contributions to both traditional IRA’s and 401ks are made with pre-tax dollars, meaning that you receive a tax break today for making this contribution. For example, if you make $100,000 and you contribute $10,000 to your 401k – your income is now reduced to $90,000 on paper since the $10,000 contribution is not considered taxable income today.
With that said, the money contributed grows tax deferred until you take a withdrawal from the account during your retirement years. At that time, the amount withdraw will be 100% taxable, since you received a tax break on the way in. As a note, if you take an early withdrawal from either account – i.e. prior to 59 1/2 - you will be required to pay income tax on the withdrawal amount, and a 10% penalty. This can be a very costly decision, which is why you should always consult with a financial professional prior to taking action.
When making these contributions, you should have a good understanding of what your marginal tax bracket looks like today, and what it could look like down the road. For example, you are married filing jointly for tax purposes and your household income is $250,000 – you and your spouse contribute $23,000 (maximum amount under age 50) to your 401k plans – this reduces your taxable income to $204,000, take the standard deduction into account and your taxable income should be around $174,000, which places you in the 22% marginal bracket.
Here, you are benefiting from getting a tax break today on these contributions, however, down the road if you believe you will be in the 24% or 32% marginal bracket, you may be creating a ‘tax bomb’ for your future self. I often see this ‘tax bomb’ come to light when I analyze the amount clients will need to withdraw from their pre-tax accounts for Required Minimum Distributions (age 73 or age 75 for most people). Moreover, a client’s lifestyle in retirement may keep them in the 12% marginal tax bracket, however, when RMD’s kick in they may automatically jump up to the 22% or 24% marginal bracket. It is very important to do some proactive tax planning in this area to make smart decisions.
On the other hand, you could be contributing while in the 32% marginal bracket and believe you will drop down to the 24% or 22% in retirement. Here, you could be better off as you are receiving a tax break at 32%, and you would withdraw at 22% or 24% - lower tax rates. Lastly, if you believe your marginal bracket will remain the same, then you are simply delaying the tax liability until years later.
A lot more goes into determining the contribution level in this area, but this is a good overview. Moreover, you may find that it makes sense to contribute to both pre-tax and ROTH buckets for tax diversification and asset location purposes.
Stay tuned for more information on ROTH accounts next week!
For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give tax or legal advice.
Distributions from traditional IRA’s and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59 ½, may be subject to an additional 10% IRS tax penalty.