Pre-Tax Investments vs. After Tax Investments

People often get confused about the terms “pre-tax” and “after-tax,” what they mean, and all that they entail.   

Fortunately, however, these terms really aren’t all that hard to understand, at least not if you can keep a few basic things in mind.

After-Tax Investments

The term “after-tax” really means just what it sounds like. This is money that you have paid income tax on before depositing it into an account or using it to purchase some other investment.

The amount that you invest is known as the “cost basis,” and once you cash in on your investment, you will only be required to pay tax on the money you’ve gained over your original investment amount. This is because you’re already paid taxes on the money you initially invested.

Pre-Tax Investments

Pre-tax investments involve investments of money, often from you or your employer, that have not yet been taxed. Pre-tax investments typically go into IRAs, retirement plans, 457 plans, or other similar plans.

Usually, there are limits put in place by the IRS on how much tax-free money you can put into such accounts each year. The money you are allowed to put in, however, will grow tax-deferred. And, best of all, you only have to pay taxes when you make a withdrawal from your account.

Of course, pre-tax investments aren’t perfect. With these accounts, you won’t enjoy lower tax rates like you would with qualified dividends and long-term capital gains. However, there are still a lot of positives to these investments, making them well worth considering.

As you can see, the concept of pre-tax and after-tax investments isn’t all that hard to understand. Understanding the difference, however, is critical when it comes to selecting the best possible investments to match your financial needs and goals.