Any Roth IRA or Roth 401(k) contributions are after-tax contributions. But that does not automatically mean that a Roth account isn’t tax-advantaged. Quite the opposite, actually!
Choosing between a pre-tax account or an after-tax account for your retirement savings should not only be made based on what type of contribution it uses. Because of their tax advantages, Roth accounts can make a lot of sense for your retirement plan. Read on to learn more about how Roth contributions work, the tax laws, and who is eligible to have Roth accounts.
What Are Roth Contributions?
When you contribute money to your Roth account, you contribute after-tax dollars. That’s money that you already paid taxes on, e.g., your income.
An example account you can make Roth contributions is a Roth IRA (Individual Retirement Account) or a Roth 401(k) (sometimes offering an employer match directly into the Roth account since the SECURE 2.0 Act was enacted at the end of 2022). This is different from a traditional IRA account, where you contribute pre-tax dollars. Such pre-tax dollars will reduce your taxable income in the year you make the contribution.
Because the money you contribute is already taxed, you don’t immediately get a tax advantage with a Roth account. Your advantage kicks in later because your contributions are allowed to grow tax-free! Yes, you read that right!
So, if you contribute $5,000 to a Roth IRA and you just let it sit for a few decades, it can grow to $50,000 or more. By the time you want to withdraw that money, you will not have to pay any taxes on your money. But you need to keep in mind the limitations for withdrawal discussed below.
The sum of all of your contributions to a Roth IRA over its lifetime is also called the basis of contribution. This number is important when it comes to withdrawing money from your account. For a detailed dive into the Roth IRA Basis Of Contribution, check out my article Roth IRA Basis Of Contributions: How Does It Work?
Pre-Tax vs. After-Tax Contributions
It is important to understand the key differences between pre-tax and after-tax contributions. Each contribution type offers different tax savings or tax benefits and other opportunities.
Pre-tax contributions – Typically, you contribute pre-tax dollars to a 401(k) or traditional IRA account. The contributions are made before your taxable income is calculated. In other words, your taxable income is lowered by the total amount of pre-tax contributions you make in any given calendar year. This is your tax advantage with such a retirement account. When you withdraw money from the account, you will have to pay taxes on the capital gain.
After-tax contributions – Money you contribute to a Roth IRA or Roth 401(k) is already taxed. You just take some of the money you earn from a job and contribute it to your account. Your tax advantage is deferred to the time you want to withdraw your money. You will not have to pay federal taxes on qualified withdrawals. Contributions in this category do not reduce your taxable income.
Tax Implications of Roth Contributions
Let’s say you contribute $1,000 after tax to your Roth IRA. You already paid the taxes on that money. Over the next few decades, that money grows to $15,000. When you meet all criteria for withdrawal, you will not pay any taxes on your capital gain at all. It’s easy to see that this is a very sweet deal, right? The taxes you pay on $1,000 initially are much smaller than the taxes you would normally pay on your capital gain of $14,000, even if you are in a lower tax bracket by the time you reach retirement age.
This tax benefit is, in essence, why I think a Roth account is a good idea for any retirement plan. There are not many ways available in the United States that allow you to enjoy your investment gains tax-free. Roth accounts are a good way to get a tax break during retirement.
Roth Accounts And Required Minimum Distributions
The RMD requirement aims to ensure that individuals with tax-advantaged retirement accounts eventually start withdrawing and paying taxes on the funds they have saved over the years.
Roth IRA and Roth 401(k) accounts do not have RMDs for the original account owner. This means that if you own a Roth IRA, you are not required to take minimum distributions from the account during your lifetime. You can continue to let your investments grow tax-free for as long as you like.
This is another great tax benefit you get with Roth Accounts.
Roth Contributions: Limits and Eligibility
You can’t put an unlimited amount into your Roth IRA account and grow your money tax-free. There are limitations you need to be aware of. Check out the official IRS website for information about Roth IRAs.
- Your contributions are taxed when you make them.
- Qualified distributions are tax-free.
- All contributions are nondeductible contributions.
The contribution limits for Roth IRA accounts are based on your filing status and your adjusted gross income (AGI):
| Filing Status | Income | Contribution Limit |
|---|---|---|
| Single individuals | <$146,000 | $7,000 ($8,000 age 50+) |
| $146,000 – $161,000 | partially eligible | |
| >$161,000 | not eligible | |
| Married filing jointly | <$218,000 | $7,000 ($8,000 age 50+) |
| $218,000 – $228,000 | partially eligible | |
| >$228,000 | not eligible | |
Roth 401(k) vs. Roth IRA
Choosing between a Roth 401(k) and a Roth IRA is crucial for individuals looking to save for retirement with after-tax contributions. Both options offer tax-free growth and tax-free qualified withdrawals in retirement, but they have some key differences.
A Roth 401(k) is typically offered through an employer-sponsored retirement plan, where employees can contribute a portion of their salary after taxes. The contribution limits for Roth 401(k)s are generally higher than those for Roth IRAs, making them a suitable choice for individuals looking to save more aggressively. On the other hand, Roth IRAs are individual retirement accounts that allow you to contribute to your own accounts. They also have more investment flexibility and control.
Additionally, Roth IRAs have income limits that may restrict high earners from contributing directly, while Roth 401(k)s have no income limits (more on that below).
The choice between the two ultimately depends on factors like your income, retirement savings goals, and investment preferences, and many individuals choose to have both accounts to diversify their retirement savings and tax strategies effectively.
Can You Have A Pre-Tax And an After-Tax Retirement Account?
Generally, you can have as many retirement accounts as you want as part of your retirement strategy. You can mix and match them as you please.
Pre-tax retirement accounts, such as Traditional IRAs and 401(k)s, allow you to contribute money before taxes are deducted from your income, reducing your taxable income in the year of contribution. On the other hand, after-tax retirement accounts, like Roth IRAs and Roth 401(k)s, involve contributing income that has already been taxed but offer tax-free growth and qualified withdrawals in retirement.
Many individuals choose to diversify their retirement savings by having a mix of both types of accounts. This diversification allows them to enjoy the immediate tax benefits of pre-tax contributions while also planning for tax-free withdrawals in retirement through their after-tax accounts. It’s a smart strategy that can provide flexibility in managing taxes during retirement and aligning with your specific financial goals.
Converting A Traditional IRA To A Roth IRA Account
The rollover of a traditional IRA account into a Roth IRA account can be a strategic financial decision.
You transfer funds from your Traditional IRA, which you funded with pre-tax dollars, into your Roth IRA, where you make your contributions with after-tax dollars. Because of that, your contributed amount will be treated as taxable income in the year of the conversion. This will likely result in a higher tax bill that year. It’s crucial to carefully plan the conversion to minimize the tax impact and ensure it aligns with your long-term financial goals.
High earners outside of the income limits discussed above are generally not eligible for a Roth Account. However, there is still the option to use a backdoor Roth conversion. While not officially encouraged, this strategy involves opening and funding a traditional IRA account and then rolling it over into a Roth IRA account. For any given calendar year, you can do that up until the tax filing deadline and not just until the end of the year. For more information, check out this article.
Final Thoughts – Are Roth Contributions Pre-Tax Or After-Tax?
Thinking early about your retirement goals is a vital step for everyone. Roth accounts are a great way to get a tax break in your retirement age as they offer a lot of potential benefits.
When you know how Roth contributions work, you will have a better understanding of what the tax advantage of a Roth account is. You now know how your contributions are different from contributions to a traditional retirement account.
Although there are many limitations for who is eligible to have a Roth IRA account, the backdoor Roth conversion still remains available for individuals with a higher income.
Disclaimer: The information in this blog post should not be considered tax advice or a replacement. They are solely provided for informational purposes. Please consult with a tax professional for any specific questions on your taxes.
Disclaimer: The information in this blog post should not be considered investment advice or a replacement thereof. They are solely provided for informational purposes. Please consult with a financial advisor for any specific questions on your financial situation. Remember that past performance is not a good indicator of future returns. Also, none of the mentioned stocks are to be understood as recommendations. Don’t buy yourself something solely based on what you read here.
You should talk to a financial advisor and tax professional if your tax situation becomes more complex. Finding a good financial advisor is not easy. I recommend the Garrett Planning Network, the National Association of Personal Financial Advisors (NAPFA), and the XY Planning Network. These networks can get you in contact with a fee-only advisor. No matter how much money we are talking about, it will not change your costs.
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