Pre-Tax vs. After-Tax Contributions

My name is Scott Johnson, and thank you for tuning in to the Financial Success Academy.

In this video, we will break down the difference between pre-tax and after-tax contributions into your 457(b) deferred compensation account.

First, I think it would be helpful to make sure that all of you understand that the term "Roth" refers to after-tax contributions, not the type of account.

Since 2010, governmental employees have been allowed to contribute on an after-tax or Roth basis into a 457(b) plan.

One of the main advantages of making Roth contributions into your 457(b) is that, unlike a Roth IRA, there are no income restrictions when making those after-tax contributions. In addition, 457(b) participants can contribute the full annual IRS limit of $20,500 on an after-tax basis if under 50 this year and $27,000 if turning 50 or older. This is significantly higher than the limit on contributions into an IRA account.

Now, what is the difference if I contribute into my 457(b) on an after-tax versus pre-tax basis, and are distributions taxed in retirement?

In the example you see now, if I contribute $10,000 into my 457(b) on a pre-tax basis this year, I will reduce my W-2 taxable income by $10,000, and my contribution will grow tax-deferred inside my retirement account. If over the course of my career, I can grow that $10,000 into $50,000, all $50,000 will come out as ordinary taxable income in retirement.

Conversely, if I contribute $10,000 this year on an after-tax, or Roth basis, I'll pay income tax this year on the full $10,000. But my contribution will grow tax-free until I take a distribution in retirement. Using this example, if I can grow my $10,000 into $50,000, all $50,000 will come out tax-free in retirement.

Finally, I'd like to briefly discuss some of the pros and cons of after-tax contributions versus pre-tax deferrals into your 457(b).

The biggest advantage of contributing into your retirement account on an after-tax basis will occur if your tax bracket today is lower than the tax bracket you will be in when you take distributions in the future. Now, no one can know for sure what their tax bracket will be in the future, but the graph you see now illustrates that U.S. tax rates today are pretty low by historical comparison.

It is also important to understand all of the potential taxable sources of income that you and/or a spouse are likely to have after you leave public service. These can include pension income for you and/or a spouse, Social Security income for you and/or a spouse, post-retirement employment income if you work after leaving public service, and distributions from all tax-deferred retirement accounts.

Another big advantage of after-tax contributions is that all pre-tax deferrals into your 457(b) account are subject to required minimum distributions (RMDs) beginning at age 72 under current tax law. Your Roth assets, if rolled into a Roth IRA after retirement, will never be subject to RMDs.

Now, there is a rule that you will need to consider before making any Roth contributions. Distributions from your Roth 457(b) account will be subject to taxation if taken before age 59 and a half. Conversely, all of your tax-deferred assets in your 457(b) can be withdrawn at any time without penalty as soon as you terminate service from your governmental employer.

Since many of you will retire between age 53 and 59 and a half, this will be an important consideration when deciding which retirement buckets to take from prior to age 59 and a half.

We hope this information has been helpful to you. As always, if you have any questions about pre-tax or after-tax contributions, please call our office, and we will be happy to discuss your individual situation and help you make the best-informed decision for you and your family. Thanks for tuning in.