Looking for the best way to cut down on taxes over your lifetime?
Retirement accounts have become one of the greatest tools available for people to build wealth. They are also one of the best tax saving tools in existence. With a little smart planning they can create a gift that keeps on giving. On the other hand, poor planning or no planning at all can reap disastrous consequences. This article will aim to provide you with an overview of the two types of retirement accounts from a tax perspective before getting into key questions to consider in your planning. My hope is that you will gain confidence in your current plan or discover there is an opportunity and take action to improve your financial future.
While there are many variations of the basic retirement account including the Individual Retirement Account (IRA), Roth IRA, Roth 401(k), 401(k), 403(b), 457(b), SEP IRA etc. they all fall into one of two categories from a tax perspective and are often referred to under the general term of IRA.
Pre-Tax Retirement Accounts: Money invested in these accounts has not been taxed. Contributions made are deducted against your ordinary income providing an up-front tax benefit. The account can grow without being taxed until the day when the funds are withdrawn.
After-Tax Retirement Accounts: Money invested in these accounts has already been taxed. Contributions made can grow and will never be taxed again. Commonly referred to as Roth Accounts.
Before moving on I think it is important to make a very important distinction between what these accounts are and what they are not. Retirement accounts are not investments. They are merely types of accounts that hold investments. These investments can include cash, stocks, bonds, real estate and bitcoin to name a few. These accounts are nothing more than an account with unique tax characteristics. I cringe every time I hear that 401(k)s are too risky because, as I just mentioned, they can hold a variety of investments including the most secure, cash.
With the understanding that retirement accounts are nothing more than types of accounts that come with tax benefits, not actual investments, let's view the accounts through the lens of taxation. Whether it is a pre-tax or after-tax account, both are subject to ordinary income tax when tax is paid. Ordinary income tax is assessed using a marginal tax rate system. This has a cascading effect with each successive dollar over a bracket being taxed at the next highest rate. An example may work best to help explain this.
Using the table below for a married couple filing jointly, let’s look at an example. Assume Fred and Wilma earn a combined annual income of $250,000 in 2025. The first $22,000 will be taxed at 12%. Dollars earned from $22,001 to $89,450 will pay tax at 12%. Dollars earned from $89,451 to $190,750 will pay tax at 22%. In this example, every dollar over $190,750 will pay tax at 24%. In total, they will pay $46,799 in tax.
To summarize, both pre-tax and after-tax retirement accounts are subject to ordinary income tax. Ordinary income tax is assessed using a marginal tax rate system with each successive dollar over a bracket being taxed at the next highest rate. The choice is whether investors would like to pay that tax today and never again with an after-tax account or avoid paying today with the obligation of paying tax in the future using a pre-tax account. There are entire books written on which is better and I don’t plan to cover all the factors here. However, I would like to address some of the key questions to answer when forming a plan.
Will your income in retirement be higher or lower than it is today? Typically, people start their careers earning very little before earning more in their later years. Then when they retire, this earned income drops considerably. This means the tax burden tends to be lower in the early years, higher in the peak earning years and then drops off again. If rates are lower today than they will be in the future, an after-tax retirement account is best. Pay tax today at the lower rate and enjoy paying no tax in the future when rates are higher. However, if rates are higher today than in the future, it makes more sense to avoid paying tax today in exchange for paying tax at the lower rate in the future.
Will tax rates be higher in the future than they are today? In 2025, the highest marginal tax rate is 37%. 37% is no small number and most would prefer not to pay it. However, it is important to look at it within the context of what it has been and where it is likely to go. Many would be surprised to find out that in 1944 the top marginal tax rate was 94%! People were then relieved to have rates go down from 1965-1981 to only 70%. That doesn’t make the rates of today sound so bad, but will they go up or down from here? Well, the first question I would ask is why does the government tax citizens? If paying off debt came to mind as one reason, you would be right. So, what is the Federal Government debt at? As of the date I’m writing this it stands at an all-time high of $36 Trillion! Check out https://www.usdebtclock.org/ for updated numbers and the chart of historical rates below. While you may not find yourself in the top tax rate today, the point I hope to make here is that rates today are at a relative low. If that is the case, why not take advantage of it by getting the tax out of the way now?
How far into the future will you plan to use the funds? With greater time between now and your retirement when you access the funds, there is greater uncertainty. It is less challenging to figure out what tax rates will be in one year than it is to make a guess at where they will be in 20 years. After-tax contributions today remove the uncertainty around taxes by paying the tax today and never having to pay tax again. On the other hand, if retirement is not that far away you may have a better idea of the tax rates you expect. If you expect to be in a lower tax bracket in retirement than you are today it may make more sense to contribute to a pre-tax account.
What kind of investment returns do you expect? If you expect your account to grow substantially over time it may be better to pay tax today. The entire balance within a retirement account is either taxed today or in the future. Paying tax today on $100,000 will be much less than paying tax on $1,000,000 in the future. Returns are hard to predict but if above average returns are possible, it may be worth considering getting the tax hit out of the way today.
Beware the Required Minimum Distributions (RMD) impact on pre-tax accounts. During your working years contributions to your pre-tax retirement account were not taxed. This means that Uncle Sam has not been paid and after waiting he would like to collect. Through RMD’s, Uncle Sam begins forcing you to take money out of your retirement account and pay tax on it. These distributions count as ordinary income and may trigger ancillary taxes that include tax on your social security or IRMAA which Ken covered in his prior article. After-tax retirement accounts have already paid tax and they do not require taking RMD’s. If this concerns you, it may be worth considering building up an after-tax balance. If you have already built up a pre-tax balance and would like to change it there are options including Roth conversions. This will be covered in future articles.
Do you enjoy working with a reckless business partner? This one may catch most people off guard but it’s an honest question. If there is money in a pre-tax retirement account, it has not been taxed yet. This means you have Uncle Sam as a business partner and every time he runs out of money, which is often, he looks to his tax sources to determine how much he needs this time. He is already comfortable asking people for tax revenue from these accounts. The only question is how much this time? If you don’t like this partnership arrangement it may be worth revisiting your strategy.
What if one spouse passes away? Earlier I highlighted the Federal Tax brackets for a married couple filing jointly. Unfortunately, if a spouse passes away the remaining spouse will no longer be able to file under the joint tax tables. The result is that if your income remains the same it will take approximately half the amount of income to jump into those higher tax brackets. This creates an extra tax burden as the surviving spouse is now forced to continue taking the same RMD amounts with less forgiveness from the tax tables. After-tax accounts are not subject to RMD rules and help remedy this issue.
At this point it should be clear there are several considerations when evaluating whether to contribute to a pre-tax or after-tax account. It may be tempting to put all your money in an after-tax account and be done with ever paying tax again but that may also not provide the best outcome. We often use the concept of “tax diversification” when meeting with clients. By funding both a pre-tax and after-tax account, money can be pulled from the after-tax account when rates are high and the pre-tax account when rates are low. Having options is a good thing and the axiom “everything in moderation” may hold true here. In the end, the best solution is to be aware of the considerations and begin planning early with a professional.
I understand that not everyone has the good fortune of planning early. In fact, I often meet with people that reach their peak earnings years, get excited about building wealth that will never be taxed again only to find out that the government does not allow these high earners to fund an after-tax account. As of today, a married couple with a Modified Adjusted Gross Income (MAGI) over $246,000 or single individual with over $165,000 MAGI is prohibited from contributing to a Roth IRA. Fortunately for high earners there are options, one of which is a workplace 401(k) with a Roth option or the “Rich Man’s Roth”. Ken will be diving into the Rich Man’s Roth in his next article.
Kyle Lottman, CFA, CMT, CPA
Wealth Management Advisor
Elevate Capital Advisors
Legal Information and Disclosures
This commentary expresses the views of the author as of the date indicated and such views are subject to change without notice. Elevate Capital Advisors, LLC (“Elevate”) has no duty or obligation to update the information contained herein. This information is being made available for educational purposes only. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Elevate believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This memorandum, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Elevate. Further, wherever there exists the potential for profit there is also the risk of loss.