Skip to main content
Message Font: Serif | Sans-Serif
 
No. of Recommendations: 0
I am fresh out of school and starting my first job. I am looking over all of the information related to the 401k program and feeling a little overwhelmed. I feel confident in selecting the Index fund that is available , however I am not sure if I should make my contributions pre-tax or after tax. It seems that I will have to pay tax down the road on both the capital gains and my employers contribution. A few people have told me to make my contribution after tax, but all the literature suggests to make contributions pre-tax. Any advice would be appreciated.
Print the post Back To Top
No. of Recommendations: 0
Your 401K plan and especially the income it makes on investments is protected from income taxes as long as it stays in the plan. You do pay taxes at regular rates (not capital gains rates) when it is paid out according to the rules after age 59-1/2. If paid out earlier, you pay additional penalties.

In many plans your contributions may be either before tax or after tax. After tax contributions are easier to remove and because they have already been taxed, they are not taxed when removed from the account. However, the before tax $$ are easier to come by because for most of us taxes take about 20% of the money you earn. These pretax $$ do come out of your marginal tax rate and can be as high as 39%.

In essence the choice between before tax and after tax is a decision on whether to pay the taxes on that money now or later. For some paying now at lower rates would be smarter. But its an individual choice. In either case should put the maximum number of $$ in the 401K you can to maximize your earnings for retirement. Maxing both before and after tax contributions is usually best.
Print the post Back To Top
No. of Recommendations: 0

I feel confident in selecting the Index fund that is available , however I am not sure if I should
make my contributions pre-tax or after tax.


stroehle,

Welcome to TMF. I suggest that you continue to read over many of the good articles and help found on this site. We can give you advice, but in the end it is up to you to decide what is best. You have plenty of time. Believe me when I tell you that you are way ahead of most everyone else by starting to invest right out of school.

If you invest in 401K/IRA plans over your working life and keep all the money invested without taking early withdrawals/loans, then it really doesn't matter too much tax-wise how you contribute to the plan. The reason is that over the long term the contributions become such a small part of the total portfolio that the taxes on the gains are more important.

Here's a simple numerical example. A $1000 invested in a US large cap index fund in 1978 is worth about $32,000 today. The taxes that are due on the gains dwarf the taxes on the contributions. And that gain occurred with only 21 years of investing. Another 10 years and the taxes on the contributions will be even smaller in comparison.

Investing pre-tax has the advantage of freeing up more take home pay now compared to the same investment made on an after-tax basis. If you invest $1000 pre-tax you will have more take home pay than if you invested $1000 after-tax. There is a detailed explanation why at http://www.401k.com/401k/pfp/rp/fringe.htm . As I have shown, your tax burden most likely will be more of a concern on your gains and not your contributions. Therefore, you are probably better off taking the extra take home pay now and deferring the taxes.

Another good reason to avoid after-tax 401K investing is due to the availability of ROTH IRA's. After-tax money invested in one of these plans incurs no tax liability if the rules are followed concerning distributions. Even a plain old taxable account can be a good option since the long term capital gains rates were lowered recently.

rustedSoul

Print the post Back To Top