What The Heck Does “Pre-Tax” Really Mean?

You may have heard the term “pre-tax” in the context of your company sponsored retirement plan (401k or similar). What you may not realize is just how beneficial, and rare, that term really is.

Let’s Assume Your Employer Offers a Retirement Savings Plan Like a 401k.

These types of tax-favored retirement plans allow participants to contribute some of their salary to their 401k account before taxes are assessed. If you don’t contribute anything to your 401k, your friends at the IRS will assess taxes on ALL of your salary.

So let’s also assume that your salary is $50,000. From that, you choose to contribute 10% per paycheck to your 401k. That means you contribute $5,000 (10% of $50,000) into your 401k. To your benefit, the IRS is now only able to tax you on $45,000, NOT your $50,000 salary. This is because your 401k contribution is taken from your paycheck pre-tax. (Note: Pre-tax does not mean you avoid any FICA taxes. You may owe Social Security and Medicare tax, for example. FICA taxes are based on gross pay.)

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120% Rate of Return

If your employer offers a pre-tax retirement savings plan like a 401k, 403b, 457, or similar and they offer a matching contribution you may be the lucky benefactor of a 120% rate of return on your contributions.

Let me explain. Lets assume the following:

$50,000 annual salary
Your employer matches 100% of the first 3% of your contribution. So if you contribute 3% of your salary to your 401k, your employer will also contribute 3% of your salary to your 401k.

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The 10% Savings Trick

We hear it quite frequently…”I just can’t afford to put aside 10% of my paycheck towards retirement.” Or sometimes…”We are just barely getting by on the income we have right now.” If you find yourself in this position then I highly encourage you to take a look into Dave Ramsey’s tools and specifically his Core Financial Wellness Program.

But if this article reaches you before you take your first full-time job and before you have car payments, credit card debt, etc. I implore you to implement the 10% Savings Trick. It is incredibly simple in its concept but massively important in its execution. It works like this…The moment you hear what the annual salary offer is (spoken or written) from your first employer – trick your brain into hearing (or seeing) a figure that is 10% less than the actual amount. If you think you hear $60,000 – immediately convert that to $54,000 in your head and base your decision on that adjusted figure of $54,000. Should you decide to accept the offer – in your mind, you will be accepting an offer of $54,000.

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401k Heads to the Gym

It seems weekly that my wife asks me when I’m going to start working out again. I usually have the same old answer, “Soon.” I can assure you that answer won’t suffice for much longer.

Unfortunately the same response can be found for many hard working Americans out there regarding their 401k, “Hey, when are you going to start saving?”

Soon.

If you think about it, your 401k is a lot like working out. Every day you tell yourself one of the following (or all three):

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100 Million Problems

According to the 2010 US Census there are now approximately 170 million people in this country between the ages of 25 and 66. By some estimates, only 51 million of these people are participating in an employer sponsored retirement plan (401k, 403b, or similar) and making 401k contributions.

So what the heck are the other 120 million working adults in this country doing to save for retirement!?!

Is it really true that roughly 7 out of 10 of us are not saving for our eventual retirement? Say it ain’t so! I realize that a small segment of these folks will receive a monthly pension upon retirement (teachers, firefighters, police officers, utility workers, etc). My guess is if you had a room full of your friends and you asked them to raise their hand if they are eligible for a monthly pension check upon their retirement, fewer than 10% would raise their hand.

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