Investing Your Money – Your Pre-Tax Money And Your After-Tax Money
The reason I’m using the terms Pre-Tax and After-Tax is because these are 2 options you have when investing your money. For example, when you invest in your 401(k) the money is taken out of your total paycheck, your gross paycheck. Let’s say your job pays you $100k/yr total, that would be $8,333/mo. You would owe taxes on this of course, so let’s say $2,933/mo would go towards taxes and the money left over which you see deposited in your checking account is $5,400.
If you decided to contribute $1,500/mo towards your 401(k) then this would actually lower your taxes. Instead of now being taxed on that $8,333/mo you would be taxed on only $6,833. Not only are you getting taxed on less money but now you have $1,500 that will grow in an investment account for you AND will grow tax deferred (you don’t pay taxes on the profits until you reach retirement age)… which means that if you buy and sell some investments you don’t have to pay taxes on the profits of that investment.
So, your 401(k) is funded with Pre-Tax money… money that hasn’t been taxed. This is the intensive the government gives you trying to encourage the masses to invest for retirement.
Investments With After-Tax Money
So, let’s compare that to investing with After-Tax money. In the above example your take-home (net) income is $5,400/mo. This is the money you see in your checking account. You naturally would use some of the money to pay for living expenses and perhaps some gambling debt (I’m not judging) and you may have some money left over that you want to invest.
Perhaps you take $1,500 of this and buy some individual stocks, or some mutual funds or some bonds. Don’t worry, we will get into the details of such investment options later. After-tax investments that you buy and sell may generate a profit and you would be taxed based on this profit. This is unlike the Pre-Tax investments above which don’t get taxed until your set retirement age. Is it a big deal? It depends but it’s certainly something to keep in mind.
Pre-Tax (or Tax Deferred) examples:
- 401(k) Plan
- 403(b) Plan
- 401(a) Plan
- 457 Plan
- Keogh Plan
- Pension Plan
- Cash Balance Plan
- Traditional IRA (if you qualify)
- a few others…
After-Tax (or Taxable) examples:
- Roth 401(k)
- Roth IRA
- Personal brokerage account
- CD (certificate of deposit)
- Money Market account
- Savings account
- Peer-to-peer lending
- Real estate investing
The pre-tax examples should for the most part make sense. These are various accounts that are approved by the IRS for you to put your money into and for which they won’t tax you until you withdraw the money in retirement. There are various reasons for this tax break but you can imagine that it’s in the country’s best interest if the elderly are financially independent otherwise it would be up to the government to take care of its aging population. Each of these accounts have unique characteristics and what it comes down to is what your company offers. If you are an independent contractor or consultant or have your own business you may be able to set up your own 401(k) or your own tax-deferred investments.
In my tax-deferred examples I take advantage fo a 401(k), a 401(a), a Pension and a Cash Balance plan. It’s not common to have so many options but this is exactly why I chose the company that I work for. I take money out of my gross paycheck and send it to my 401(k) company (which is serviced by a large brokerage company) and my employer puts money into a 401(a) and a Cash Balance plan on my behalf. They also put money into my Pension which is serviced by another brokerage company.
Examples of After-Tax/Taxable Accounts
We’re almost done… I know you’re probably getting indigestion reading all this. So, the after-tax investments are the more obvious things such as a savings account, a CD or a money market account. You put your after-tax money in there, the bank/financial institution gives you a tiny percentage in interest on which of course you will be taxed. You can also open your own brokerage account such as with Fidelity, Charles Schwab, Etrade, Vanguard and invest money into that account. I, for example, have some money in a savings account (enough that I can access in case I need emergency dental work done or if my goldfish gets critically ill and has to spend time in the ICU). I have money in a money market account (not much different from a savings) and I have money in a personal brokerage account where I buy mutual funds. I used to own individual stocks in a different brokerage account but I don’t have enough time researching individual companies to make good investment choices so I’m sticking with mutual funds for now.