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.)

To Now Illustrate The Benefit to You, Here is How The Math Works:

$50,000 taxed at 20% = 10,000 in Federal taxes
$45,000 taxed at 20% = $9,000 in Federal taxes

So not only have you socked away badly needed funds for your retirement, you have also managed to cut your tax bill by $1,000 in the process! The only loser in this equation is the IRS. Another way to look at this benefit would be to say that you only had to put $4,000 of your own money away for retirement and the IRS kicked in another $1,000. Keep in mind: The more money you make, the higher the tax bracket you could be in. This means you get an even bigger tax benefit when you contribute to your 401k. You can also increase your tax benefit by increasing your contributions. In 2018, if you are under age 50, you can sock away up to $18,500 pre-tax into your 401k.

There Are Very, Very Few Things Left in This World Where You Can Use Pre-Tax Dollars…

Please do not miss out on taking advantage of this one. So go ahead, thumb your nose at the IRS and stick as much money as you can into your 401k. Your future retirement lifestyle thanks you!

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.

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