DEFINITION of Pretax Contribution
A pre-tax contribution is any contribution made to a designated pension plan, retirement account, or other tax deferred investment vehicle in which the contribution is made before federal and municipal taxes are deducted.
BREAKING DOWN Pretax Contribution
Contributions made to a retirement savings plan can be pre-tax and/or after-tax contributions. If the contribution is made with money that an individual has already paid tax on, it is referred to as an after-tax contribution. After-tax contributions can be made instead of or in addition to pre-tax contributions. A lot of investors like the thought of not having to paying taxes on the principal when they make a withdrawal from the investment. However, after-tax contributions would make the most sense if tax rates are expected to be higher in the future.
A pre-tax contribution is payment made with money that has not been taxed. The traditional IRA, 403(b), 457, and most 401(k) plans are examples of a tax-advantaged accounts that allow retirement planners make annual pre-tax contributions. Employees can contribute to a 401(k) plan using income that has not been subject to payroll or income taxes. The employee only pays ordinary income tax on his or her contribution and earnings when s/he withdraws from the account. In addition, because pre-tax contributions reduce the amount of taxable income and, hence, income tax an employee owes each year, s/he can afford to contribute more pre-tax than after-tax.
For example, consider an employee that earns $75,000 gross income in a given tax year. If his effective tax rate is 24%, his tax liability for the year will be .24 x $75,000 = $18,000, leaving him with $75,000 – $18,000 = $57,000 take home pay. However, if he contributes $15,000 towards his 401(k) plan, his taxable income will be reduced to $75,000 – $15,000 = $60,000 and his tax liability will be .24 x $60,000 = $14,400, less than $18,000. In calculating a pre-tax contribution, as this example shows, the amount of taxes withheld will be reduced, as the basis for the taxable amount will be reduced.
Unlike the pre-tax contribution plans, the Roth IRA is an after-tax contribution plan. While taxes are paid on withdrawals from pre-tax contribution plans, tax is paid on Roth contributions now, but their earnings can be withdrawn tax free. An individual that is torn between making pre-tax or Roth contributions to his retirement plan should compare his current tax bracket with what he thinks it will be in retirement, which would depend on his taxable income and the tax rates in place when he retires. If he expects it to be lower, pre-tax contributions will probably be more advantageous. If he expects it to be higher, he may be better off with a Roth IRA.
Making pre-tax contributions is beneficial to those who are eligible, as this will reduce the amount of taxes paid at that time. After all, it is always better to defer payments due to the time value of money.