Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Pre-Tax Contribution

What it is:

A pre-tax contribution is a payment made with money that has not been taxed.
 

How it works (Example):

Anybody can take a portion of their monthly pay and put it in a savings account. But that’s after-tax money, meaning that by the time you get it, the government has already taken a piece out.

But a great example of tax-advantaged investing using pre-tax contributions is the 401(k) plan. Offered by employers, these plans allow employees to save for retirement right out of their paychecks. The primary tax advantage is that employees contribute to the retirement plan with money that hasn't been hit with payroll taxes yet -- that is, they make pre-tax contributions.

So, for example, if your salary is $1,000 a week and the tax rate is 25%, you bring home $750 a week after taxes. One way to invest that money is to just put, say, $200 of that after-tax money in a savings account, leaving you with $550 to pay the rest of your bills. But a more sensible tax-advantaged strategy, which involves pre-tax contributions, would be to put the $200 in a 401(k). Here's the math:

Gross earnings: $1,000
401(k) contribution (made pre-tax): $200
Net earnings: $800
Tax rate: 25%
Take-home pay: $600

In the first scenario, you make $1,000, bring home $750, and put $200 of that in a savings account, leaving you with $550. In the second scenario, you still make $1,000, still save $200 (in a 401(k) account), but have $600 left over -- that is, you make and save the same amount every month, but you end up with an extra 50 bucks. That’s the power of making pre-tax contributions, and that’s why even if your employer doesn’t offer a match to your 401(k) plan, you should still contribute.

Why it Matters:

Pre-tax contributions allow a taxpayer to reduce his or her tax burden. They are a cornerstone of retirement and estate planning for many people. Without it, investors can see dramatic long-term differences in their portfolios because they are able to defer or minimize their taxes.