When it comes to financial accounts, such as retirement
plans, for example, there are a lot of details and a lot of jargon used to
discuss these accounts. Unfortunately, if you are not familiar with these terms
and phrases, it can all get to be a bit confusing and overwhelming. That’s
where it really helps to have a financial professional on your side assisting
you and walking you through the process.
Even if you don’t have such help, though, one of the most
important things you can learn is the difference between “pre-tax” and“after-tax” accounts. Knowing this information alone can really help you to
make smart and informed choices about the accounts that you open.
Pre-Tax Accounts
To start off with, pre-tax accounts are accounts into which
you can put in pre-tax funds.These include accounts like:
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IRAs
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Pensions
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401(k)s
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457 plans
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Profit sharing accounts
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403(b) plans
Using these types of accounts, the IRS allows you to put
some untaxed money into them. There, these funds can grow undeferred, which
means you won’t have to pay taxes on interest income, capital gains, or
dividend income associated with the account
until you take a withdrawal.
Basically, with these types of accounts, you are “home free”
until you make a withdrawal; once you have done that, you are subject to being
taxed.
After-Tax Accounts
After-tax accounts are, as the name implies, accounts that
are comprised of funds from which you have already paid taxes. These accounts
might include:
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Savings accounts
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Mutual fund accounts
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Brokerage accounts
The good news about these types of accounts is that when you
“cash in” on an investment from them, you only have to pay taxes on the gain
that is above the investment amount. This can actually lead to paying less in
taxes, believe it or not, than having only pre-tax accounts!
While you may be leaning toward one type of account or the
other, the truth is that both have their own benefits as well as their
drawbacks, which is why many people actually find it smart to have a mix of
both types of accounts. The best way to determine what would be the best
account choices for your particular financial situation and future financial
goals is to talk with a qualified tax professional.