Here you are reading up on finances. Bravo! For this reason alone, we’re going to assume that you’re a responsible adult. You probably set a budget, pay your bills on time, and do your best to save for retirement.
But if you’re like many people, you may not be sure what a pre-tax 401k is really all about. You may even be catching yourself wondering, “What does pre-tax mean, and how does it affect your 401k?” Don’t worry, the blooom team is here to break it down for you.
What Is Pre-tax 401k?
A pre-tax contribution is any money put into a retirement account before taxes are deducted. This means you’ll have a smaller taxable income and have fewer taxes withheld. For example, if you start contributing to a pre-tax 401k and put $5,000 in the account through payroll contributions, you won’t have to pay income tax on that $5,000 when tax season rolls around.
How to Work 401k Pre-tax Dollars to Your Advantage
A pre-tax 401k is an incredible opportunity to put your hard-earned money to work. Your money will grow with interest as it sits in the retirement account. And as an added bonus, many employers will match your contributions at an average rate of 4.2%. This will give you peace of mind as you put away money for your future—but it also gives you an impressive tax break today!
Just to give you even more incentive to get your 401k established, let’s consider an example. If you made $50,000 and were taxed by the government at 20%, you would owe $10,000 in federal taxes that year. But if you put away $5,000 in a 401k, your taxable income would be just $45,000. When taxed at the same 20% rate, you would owe only $9,000. You’ve given yourself a tax-break today, and you also get to enjoy the added benefits of tax-deferred growth between now and when you retire.
Beware: 401k Penalties
The perks of a 401k sound pretty amazing, right? As you may have caught onto, we highly recommend cashing in on this opportunity to save now and in the future. But before you get started, there are some 401k penalties you need to know about. Being educated about the ins and outs of a 401k will allow you to maximize your savings to the fullest.
Early Withdrawal Fees
So here’s the catch: If you take money out of your 401k before you’re 59 ½ years of age, you’ll usually have to pay a 10% penalty fee on top of the taxes that will be due upon withdrawal. This can significantly cut into the money you’ve saved for retirement, so we strongly discourage against early withdrawal if at all possible.
There are, however, a few exceptions to the early withdrawal penalty. If you need the money to pay for hardships like college tuition, to prevent an eviction or foreclosure, or to pay for a funeral, you won’t have to pay the 10% fee. (But note that you will still need to pay taxes on the money that you take out and we still only recommend this as a last resort.)
So are there any other penalties you should know about? Yes, but these penalties are usually easier to avoid once you know about them. The IRS sets limits on how much you can contribute to your 401k in a year, and if you go over those limits, you’ll be penalized. As of 2020, the maximum yearly 401k contribution is $19,500. This means if you go over that amount, you’ll have to include that money in your taxable income for the year and pay double tax on the excess amount unless the money is removed in the time permitted.
Retirement Accounts That Allow Pre-tax Contributions
With all of that penalty talk out of the way, we can move on to better news. Though 401k accounts are one of the most popular pre-tax accounts, there are actually several others that allow you to contribute money without paying income tax. Yes! Here are the other retirement accounts that allow pre-tax contributions:
- 457 plans: Some government and nongovernment employers offer this tax-advantaged retirement plan in addition to a 401k.
- Traditional IRAs: Unlike a 401k that must be opened through your employer, a traditional IRA can be opened by anyone. Check with your tax advisor to confirm you’re eligible for tax-deductible contributions.
- Simple IRAs: People who are self-employed may be eligible for this type of IRA, which allows individuals to contribute more money than a traditional IRA.
- SEP IRAs: A SEP IRA is another type of retirement account available to people who are self-employed.
- 403b plans: This type of plan is like a 401k, but is only available to people in specific professions, such as nonprofit work or healthcare.
- HSAs: A person can open a health savings account to save money for certain healthcare expenses, but they can also be used as an investment vehicle for retirement.
Why Pre-tax Dollars Are Worth the Consideration
There are very few chances for you to use pre-tax dollars in today’s world, so you’d be crazy not to take advantage of all a 401k has to offer.
Ready to learn more about the benefits of a 401k? Blooom is eager to give you expert financial advice and help you get the most out of a 401k. Our algorithm-based software allows anyone to diversify their retirement fund and invest in funds with the lowest fees. Sign up for your free, personalized analysis today.
Blooom does not provide tax advice. Consult a tax expert for tax-specific questions.
This article has been updated since its first publication in 2014.