What the heck does “pre-tax” really mean?

You may have heard the term “pre-tax” used 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 That 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 would be assessing taxes on ALL of your salary.

So let’s also assume for this illustration that your salary is $50,000 and that you have elected to contribute 10% of your paycheck to your 401k. That means you are contributing $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 because your 401k contribution is taken from your paycheck pre-tax. (Note: Pre-tax does not mean you avoid any FICA taxes, e.g. Social Security and Medicare tax, you may owe. 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 for you. Keep in mind, the more money you make the higher the tax bracket you could be in which means the bigger tax benefit you get by contributing to your 401k. You can also increase your tax benefit by contributing more to your 401k. In 2014, if you are under age 50 you can sock away up to $17,500 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.

Chris Costello

Chris Costello is the CEO and Co-Founder of blooom - one of the nation’s fastest growing robo-advisors aimed at helping millions of underserved retirement savers. Chris has earned the prestigious CERTIFIED FINANCIAL PLANNER™ designation and has been working with individual clients and building portfolio allocations for over two decades.

Prior to blooom he co-founded another investment advisory firm that grew to manage over $500 million for clients. At blooom, Chris leads the company in building innovative financial services to reach a brand new audience of under-served Americans. Blooom has been named one of the world’s most innovative companies by Fast Company, and Chris was selected as “Ten to Watch in 2016" by WealthManagement.

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