What is Pre-Tax and How Can It Help Me?

I get this often during my conversations with my newer clients. Some, when they first hear the term cannot wrap their heads around the concept until they see how the numbers work in their favor. Let's take a few minutes to define what pre-tax is and how it helps you.

If you have a retirement savings plan like a 401(k) or a 403(b) account (and others that are considered  "Qualified", a topic for another post), you can contribute to that account BEFORE you are assessed income taxes. The amount you contribute would actually come off of your salary and you do not pay the taxes on that contribution until you retire. It is a generally assumed that most of us will be in a lower tax bracket during our retirement years than we are in our working years. That would mean you would pay a lesser tax on that money during your retirement years because you put it away years earlier and it grew.

An example of how this works that makes the concept a bit more concrete:

Let's say you make $50,000 annually and place 10% of your salary into your retirement plan. That 10% would not be considered income so instead of your tax return reflecting a $50,000 salary, it would show  $45,000 salary. ($50,000 - 10% = $45,000) You would only pay taxes based on the $45,000 and the tax on the 10% or $5,000 would be deferred until you retire.

So, how can this work for you in addition to the tax benefit just described above?

If you are in the 25% tax bracket and contribute $500 per month, with 0 or 1 allowances, you could be putting in your retirement up to $665 per month but only see a $500 reduction in your net pay because of the pre-tax concept.

I do this for my clients all the time because I have a calculator that, when I input data from their payslip, it will show how much of that pre-tax money can be added to their contribution and set aside for their future income, INSTEAD of giving it to the IRS.

Over the course of 12 months, instead of socking away $6,000 ($500 x 12 months), you would actually be putting in $7,980 ($665 x 12 months). How cool is that?

Of course, everyone is unique and the numbers will vary with your income, allowances and tax bracket. I can help you figure out the numbers if you ever need me to. Just ask.

jnutting@myretirementguru.com

What is a 401(k) Plan?

A 401(k) account is most often used for private sector employees. They are similar to IRA accounts. 

• The contributions are tax-deductible

• The contributions come straight out of your paycheck

• Sometimes your employer will match some of your contributions

• Sometimes your employer will offer profit-sharing contributions

• Some plans require a vesting period, meaning if you leave your job within a certain period of time, you may lose part of your matched or profit-shared contributions; after that period of time, you are vested and the entire contribution is yours

• Leaving a job before that vesting period is complete can cost you a lot, so watch that schedule carefully

The money you save in a 401(k) grows tax-deferred which means you will not pay taxes on the growth of your money until you retire and even then, for most, the tax rate will be lower after retirement.