What’s the Difference Between “After-Tax” and “Tax-Deferred”?
Wednesday, March 1, 2017, 6:00 AM | Leave Comment
Everyone who enters the work force looks forward to the day they can retire. This should be a comfortable time of life when you can relax and enjoy the fruits of your labor.
However, for millions of people retirement can be a time of financial stress and worry about how to maintain their lifestyle on a fixed income.
The best way to ensure a successful retirement is to begin long-term savings as early as possible.
For the best outcome, you need to understand the terms after-tax income and tax-deferred investments.
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AFTER-TAX INCOME
To determine how much money you can afford to invest in a long-term savings plan, you need to look at after-tax income.
This is the amount of cash you actually have after taxes are paid, or disposable income. To calculate your after-tax income, start with your gross income and subtract federal, state, and local taxes.
For example, someone who earns $50,000 (gross wages) with $10,000 in deductions would have $40,000 taxable income.
If he paid $5,000 in combined taxes, his after-tax income would be $45,000 ($50,000-5,000). Subtract your fixed living expenses, and the balance is called discretionary income. This is the amount you look at to determine how much you can afford to invest for your future retirement.
The next step is to decide how to invest it.
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TAX-DEFERRED INCOME
Tax-deferred income is investment earnings that is allowed to accumulate tax-free until you actually receive it.
This means that the interest, dividends, and capital gains that you earn are not taxed in the year you earn them.
You pay the tax on these earnings the year you pull them out of the account. The most common type of tax-deferred long-term savings is an individual retirement account (IRA).
There are 2 advantages to tax-deferred income.
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Tax-free growth
Tax-free growth means your investment account will grow at a higher rate. The money you would have to pull out to pay for taxes each year stays in the investment account and also accumulates interest.
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Lower tax rate
Pre-retirement tax rates will be higher than post-retirement rates. Tax rates could be as high as 33% during your high income years, but they will be much lower after retirement. Waiting until you retire to pull the profit out of a tax-deferred income account means you pay a lower tax rate and less in taxes.
There are 2 different types of tax-deferred accounts: qualified vs nonqualified.
Qualified tax-deferred accounts allow you to invest “pre-tax” dollars. This means your investment is taken out of your gross income before taxes are calculated.
Going back to our simple example, if you invest $5,000 in a qualified tax-deferred account your taxable income after deductions would be $35,000. Taxes on $35,000 are lower than taxes on $40,000. A common example of a qualified tax-deferred account is a 401k.
Nonqualified accounts are paid in after-tax dollars. While you do not get an immediate tax benefit like you do with qualified plans, you still get to defer the gains until after you retire.
There are 2 advantages to nonqualified plans.
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There is no limit to how much you can invest in nonqualified plans. Qualified plans limited annual contributions, currently at $5,500.
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The second advantage is that there is no IRS penalty for early withdrawal. If you take money out of a qualified plan before the age of 59.5, the IRS levies a 10% penalty against the interest earned, plus your tax rate.
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Planning for retirement can be confusing. However, if you understand the difference between tax-deferred and after-tax investments, your retirement plan will be a successful one.
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