Investing Wth Pre-tax vs Post-tax Dollars
Investing Wth Pre-tax vs Post-tax Dollars
There are a ton of different ways to grow your money in different investing accounts. Common ones you may have heard of include: 401k, IRA, ROTH, or just a regular stock investing account like one available from E*trade or Robinhood.
Did you know that it is different kinds of money that goes into each account - and why this matters
Pre-tax dollars are monies that have yet to be taxed by the government - you made $1000 you choose to invest $1000 you get all $1000* placed into an investment account (*minus social security and medicare tax possibly - these are hard to avoid)
Post-tax dollars are monies that have already been subjected to any city income tax, state income tax, federal income tax, social security and medicare tax (woof lots of taxes - try to avoid some) You made $1000 you choose to invest but after taxes your only have $750 to invest with.
Retirement accounts and investing accounts each take a different type of money in - either pre-tax or post-tax dollars - each with their own respective characteristics :
401k - the most common you will hear about in the work place. You place pre-tax dollars into this account. This allows your money to grow before it is subjected to tax. So if you made $1000 on your next paycheck - and you placed $200 to be placed into your 401k - only $800 of your check would be subject to income taxes. The $200 dollars that you set aside into the 401k would be invested typically into a mutual funds that you or your company allocated towards. The $200 then grows tax free (meaning if you returned in a year and the initial $200 was now worth $250) you are still not subject to taxation on this newly earned $50.
The advantage here is two fold:
1) you have more money to invest with because you are investing with pre-tax dollars - less money is taken away from you by taxation before it is invested.
2) You have the potential to decrease your income tax bracket - see here for more info The catch to the 401k tax advantage status is that taxes will be due when you take the money out. Click here for more specifics on how a 401k works.
IRA - An IRA is an "individual retirement account" also known as the "traditional IRA" to distinguish it from the "ROTH IRA." An IRA works similar to a 401k in that pre-tax dollars are used here. However - instead of your employer taking the money directly out of your paycheck (like in a 401k) - you will need to deposit the money yourself and then claim a deduction on your taxes when filing. Moreover - anyone can open a IRA and you do not require and employer or anyone else to sponsor you. This added task adds a bit more work to use an IRA - however it does have the advantage of having more freedom of investment options - you are not only isolated to the stocks or mutual funds in your employers 401k. Rather you can invest in your favorite stocks and create much more individualization to your investment. Similar to the 401k - you will owe taxes on monies earned once you withdraw from the traditional IRA. In the meantime - it too can grow tax free. Because of the tax advantage similarities between a 401k and traditional IRA - consider maximizing your 401k contributions (if so an option) before thinking about opening a traditional IRA as well. Click here for more info.
ROTH IRA - A ROTH IRA is in many ways similar to a traditional IRA in the investment options available and the ability to open one at anytime. However, an important distinction is that post-tax dollars are used to fund this account. Unlike the traditional IRA you can not tax deduct any money you place into this type of account - a tactic used in previous examples to help lower income taxes due at the time. A large advantage the ROTH IRA does provide is that no taxes are due on any earnings made in a ROTH IRA. So if you placed $200 into a ROTH IRA and it grew into $250 - you do not owe any taxes on this money earned - even when it comes time to cash out- an important distinction between the ROTH and the the previous two types of accounts. See more about a ROTH IRA here.
Non Tax Advantage Trading Account - this can refer to any stock trading account that is not in a tax advantaged status account (401k, IRA). You used post tax dollars to invest - and pay taxes immediately on any income made as you have access to the funds without age restriction (as in the accounts mentioned above intended for retirement). The advantage of this type of account is that you can take your money anytime you like. The obvious disadvantage is that taxes are due on an earning you make during a given year and not delayed. There is also no ability to offset your tax bracket as a 401k or traditional IRA may provide. This type of account can set up easily and free with brokerages such as Robinhood. It is a better choice for money not set aside for retirement but you would like to invest with.
When deciding what to invest in and how - consider asking yourself not only what type of account you would like but what type of money goes into it and how this could affect your overall money goals.
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