What Are Pre-Tax Contributions?

Pre-tax, after-tax, who cares? Everything gets taxed, right? Well, not always. There are some employee benefits that are never taxed, and you can also benefit from deferring taxes for many years.

Below, we’ve broken down the basics of pre-tax contributions so you can understand the value of taking advantage of them and determine whether it’s worthwhile to incorporate pre-tax investing into your retirement planning strategy.

What are pre-tax contributions?

A “pre-tax contribution” refers to money that comes out of your paycheck and is directly invested before that income is taxed.

What are the benefits of pre-tax contributions?

There are several key benefits of pre-tax contributions:

• It reduces your taxable income.
• With a lower income, you may be eligible for a lower tax rate.
• It’s great motivation for investing more in your retirement.

How do pre-tax contributions work?

When you make contributions to your employer’s 401(k) plan, your contributions aren’t currently taxed. That means the money that would ordinarily have gone to income taxes can be invested to grow in your 401(k) plan.

Sure, you’ll have to pay tax on that money down the road when you withdraw it, but over time it will go up in value, and you’ll get to keep the earnings that remain after paying those taxes.

And it’s likely that your taxable income will be less in retirement, so you’ll be in a lower tax bracket than you are now. (Note that contributions to 401(k) plans are currently taxed for payroll taxes, such as Social Security, Medicare, and the like).

What’s the alternative?

If you make contributions to a Roth 401(k) plan, you’ll have to pay tax now on the funds you put in. The big tax advantage is that the growth on those funds is never taxed in the future, so you can draw those funds out tax-free in retirement.

That’s a big advantage for younger savers who have years and years to save for retirement and lots of tax-free growth on those savings ahead of them. For older savers, the current tax savings offered by a tax-deferred 401(k) is a better bet.

What Tax-Deferred Savings Mean for You

Let’s say that 25% of your wages are withheld for federal and state income taxes, and that you determine you can spare $100 from your net paycheck to save for the future.

You could just take $100 from your net pay and set it aside in an investment, but here’s a better idea: If you contribute that $100 to a pre-tax plan such as your 401(k) plan at work, because that $100 isn’t currently taxed, you’re saving $25 in current income taxes.

Take advantage of benefits that aren’t taxed

If an employer pays the cost of medical or dental insurance for its employees and their dependents, those payments are not taxed to the employee for either income or payroll taxes.

Other non-taxable benefits you can receive from your employer include employee discounts, health club benefits, meals on the premises, some child care benefits, and employee parking. Voluntary contributions to Section 125 plans for medical costs, child care, and the like are also never taxed if the funds are used for those expenses.

Still have questions? Don’t worry about knowing these tax rules. Meet with a TurboTax Full Service expert who can prepare, sign and file your taxes, so you can be 100% confident your taxes are done right. Start TurboTax Live Full Service today, in English or Spanish, and get your taxes done and off your mind.