Multiple options exist for tax-advantaged retirement accounts. Some of these account types are funded with pre-tax dollars, and others with after-tax dollars. The rules regarding withdrawals from each account type vary, and early withdrawals may incur additional taxes and penalties.
Some retirement accounts are funded with pre-tax dollars, meaning that the contributions to the retirement plan are deducted from your wages, and you don't pay income tax on those earnings. The most common pre-tax accounts include 401(k) plans and traditional IRAs. Since money put into these accounts has not already been taxed, any future withdrawals count as normal income and are subject to your regular income tax rate. In addition, if you have not met requirements pertaining to the age of the account itself, or your own retirement age, then an additional 10-percent early-withdrawal penalty may also apply.
After-tax retirement accounts are funded using income that you have already been taxed on. Since your contributions have already been taxed, you can generally withdraw the value of your contributions without paying additional income tax. If you withdraw investment earnings from the account, however, you must pay income taxes on that money. If you do not meet age or other requirements for the withdrawal, you must also pay the additional 10-percent penalty for early withdrawal. The most popular type of after-tax retirement account is the Roth IRA, which has the added benefit that your withdrawals after reaching retirement age are completely tax-free. Many 401(k) plans also allow after-tax contributions, so check with your employer to find out if this is an option under your plan.
Tax-deferred accounts refer to any type of investment account in which the earnings on your investments are not taxed until you withdraw them. Tax-deferred accounts are typically retirement accounts funded with pre-tax dollars. The traditional IRA, 401(k) plans, and the SEP IRA and SIMPLE plans for self-employed individuals are all examples of tax-deferred accounts. Early withdrawals from all of these account types are subject to regular income taxes plus a 10-percent early withdrawal penalty. The beauty of tax-deferred accounts is that your money grows faster, since you can earn additional investment returns on the money that would ordinarily have to be paid out to the government each year.
To get the most return out of your investments, it's best to utilize tax-free and tax-deferred accounts. When considering your annual tax and personal finance plan, it's generally advisable to contribute the annual maximum to these types of retirement accounts before allocating investment funds to non-retirement accounts that do not have any tax advantages, regardless of your age or situation. If your employer offers a 401(k) plan, make sure to contribute at least enough pre-tax dollars to this account to receive your entire employer matching contribution. Younger workers in particular tend not to contribute sufficiently to their employer retirement accounts. In addition, consider placing as much of your after-tax income as you can into your own Roth or traditional IRA. Roth IRAs in particular are attractive to those that are closer to retirement that also have other pension or retirement funds, as tax rates are not expected to decline in the next decade.
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