What Is a Pretax Contribution? How It Works and Example

What Is a Pretax Contribution?

A pretax contribution is any contribution made to a designated pension plan, retirement account, or another tax-deferred investment vehicle for which the contribution is made before federal and municipal taxes are deducted. For example, if you put in $10,000 to a 401(k) plan, you do not have to pay tax on that $10,000 of income in the year that it was earned. Pretax contributions are the government's way of encouraging you to save for your retirement.

Understanding Pretax Contributions

Contributions to a retirement savings plan can be in the form of pre-tax and/or after-tax contributions. If the contribution is made with money for which an individual has already paid tax, it is referred to as an after-tax contribution.

After-tax contributions can be made instead of or in addition to pre-tax contributions. Many investors like the thought of not having to pay 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.

Tax-Advantaged Accounts

A pre-tax contribution is a payment made with money that has not been taxed. The traditional IRA, 403(b), 457, and most 401(k) plans are examples of tax-advantaged accounts that allow retirement planners to make annual pre-tax contributions.

Employees can contribute to a retirement plan using income that has not been subject to payroll or income taxes. The employee only pays ordinary income tax on their contribution and earnings when they withdraw money from the account. In addition, because pre-tax contributions reduce the amount of taxable income and, thus, income tax an employee owes each year, an employee 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 0.24 x $75,000 = $18,000, leaving the employee with $75,000 - $18,000 = $57,000 take-home pay. However, if that employee contributes $15,000 towards their 401(k) plan, their taxable income will be reduced to $75,000 - $15,000 = $60,000, and their tax liability will be 0.24 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.

After-Tax Contribution Plans

Unlike pretax 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 who is torn between making pretax or Roth contributions to their retirement plan should compare their current tax bracket with their expected tax bracket at retirement. The bracket that they fall under at retirement will depend on their taxable income and the tax rates in place. If the tax rate is expected to be lower, pre-tax contributions are likely to be more advantageous. If the tax rate is expected to be higher, the individual may be better off with a Roth IRA.

Making pre-tax contributions is beneficial to those who are eligible as it reduces the amount of taxes paid at that time. After all, it is always better to defer payments due to the time value of money.