What Is a Pre-Tax Deduction? And How Does It Affect Your 401k?

Ardent Authors Photo

Jason Lavender

Ardent Authors Photo

Jason Lavender

Jason Lavender

Jason Lavender

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Here you are reading up on finances. Bravo! For this reason alone, we’re going to assume that you understand the importance of reaching your financial goals. You probably set a budget, pay your bills on time, and do your best to save for retirement.

But if you’re like many people, you may not be sure what a pre-tax 401k is really all about. You may even be catching yourself wondering, “What does pre-tax mean, and how does it affect your 401k?”

Check out the video below for a quick primer on how pre-tax retirement contributions work. For even more resources, visit our Financial Edge Academy module to understand more about pre- and post-tax contributions and learn everything you need to know about saving for retirement.

But for now, let’s circle back to the term “pre-tax” and explain why it’s important and what it means for your retirement.

What is a Pre-Tax Contribution?

A pre-tax contribution is any money put into a retirement account before taxes are deducted. This means you’ll have a smaller taxable income and have fewer taxes withheld. For example, if you start contributing to a pre-tax 401k and put $5,000 in the account through payroll contributions, you won’t have to pay income tax on that $5,000 when tax season rolls around.

How to Work 401k Pre-tax Dollars to Your Advantage

A pre-tax 401k is an incredible opportunity to put your hard-earned money to work. Your money will grow with interest as it sits in the retirement account. And as an added bonus, many employers will match your contributions (which is basically free retirement money). This will give you peace of mind as you put away money for your future—but it also gives you an impressive tax break today!

Essentially, pre-tax deductions are the government’s way of incentivizing you to save for retirement. And, just to give you even more incentive to get your 401k established, let’s consider an example. If you made $50,000 and were taxed by the government at 20%, you would owe $10,000 in federal taxes that year. But if you put away $5,000 in a 401k, your taxable income would be just $45,000. When taxed at the same 20% rate, you would owe only $9,000. Thanks to pre-tax deductions, you’ve given yourself a tax break today, and you also get to enjoy the added benefits of tax-deferred growth between now and when you retire.

Retirement Accounts That Allow Pre-Tax Contributions

Though 401k accounts are one of the most popular pre-tax accounts, there are actually several others that allow you to contribute money without paying income tax. Here are the other retirement accounts that allow pre-tax contributions:

  • 457 plans: Some government and nongovernment employers offer this tax-advantaged retirement plan in addition to a 401k.
  • Traditional IRAs: Unlike a 401k that must be opened through your employer, a traditional IRA can be opened by anyone. Check with your tax advisor to confirm you’re eligible for tax-deductible contributions.
  • Simple IRAs: People who are self-employed may be eligible for this type of IRA, which allows individuals to contribute more money than a traditional IRA.
  • SEP IRAs: A SEP IRA is another type of retirement account available to people who are self-employed.
  • 403b plans: This type of plan is like a 401k, but is only available to people in specific professions, such as nonprofit work or healthcare.
  • HSAs: A person can open a health savings account to save money for certain healthcare expenses, but they can also be used as an investment vehicle for retirement.
What Is a Pre-Tax Deduction? And How Does It Affect Your 401k?

Get started building your future now at TFNB

The bottom line? There are very few chances for you to use pre-tax dollars in today’s world, so you’d be crazy not to take advantage of all a 401k has to offer. Yet, it’s only one of a plethora of different ways you can boost your funds and secure your future.

The banking officers at TFNB have the knowledge and tools to help you develop a savings strategy that will support you comfortably throughout your golden years.

We pride ourselves on being your bank for every part of life—including retirement. If you have more questions about saving, retirement, your 401(k), or your Roth IRA, our team is just a phone call (or a few blocks) away!

If you have any questions or would like to know more about our banking solutions, contact us at 254-840-2836

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