A pre-tax contribution refers to a contribution to an investment account using money that has not already been taxed. Pre-tax contributions are considered ‘tax-qualified’ money and are most commonly used in individual retirement accounts (IRAs) and employer-sponsored retirement planning accounts such as 401(k) plans.
If a contribution to an investment account has already been taxed, it is considered ‘non-qualified’, or a post-tax contribution.
Traditional Individual Retirement Account
A traditional individual retirement account, or IRA, is a popular type of retirement account that is funded using pre-tax contributions. This works by the investor deducting from their taxable income the amount that they contribute to their IRA in a given year. The IRS sets limits on how much in pre-tax contributions a person can contribute annually.
In exchange for this favorable tax treatment, withdrawals from a traditional IRA are fully taxable at the investor’s top marginal income tax rate. In addition to this income tax, withdrawals taken before age 59½ are subject to a 10% penalty tax.
The 401(k) is another popular account type that is funded with pre-tax contributions. 401(k)’s are established by businesses as a way for their employees to save for retirement. Employers can also match their employees’ contributions to incentivize savings.
Pre-tax contributions to a 401(k) are deducted right from the employee’s paycheck, so no extra work is required on the part of the employee. At the end of the year, the employee’s W-2 tax form will report their taxable income with the 401(k) contribution already having been deducted.
As with an IRA, withdrawals from a 401(k) are fully taxable. The 10% penalty for withdrawals before age 59½ also applies.
The Roth IRA as an Alternative to Pre-Tax Accounts
Not all retirement planning accounts use pre-tax contributions. The Roth IRA is a popular plan type, and it is funded using non-qualified money. Although there are no tax benefits up front, withdrawals from a Roth IRA can be completely tax-free if certain conditions are met.
Firstly, as with a traditional IRA, qualifying withdrawals must be made at age 59½ at the earliest. Secondly, contributions must have remained in the account for at least five years. If both of these conditions are met, Roth IRA income is tax-free.
Pre-Tax Contribution in Retirement Planning
Pre-tax contributions are popular, but that doesn’t make them the right choice for everyone. When deciding on a plan type for retirement savings, consider not only your current financial situation but what things could look like in the future.
For those who expect to have lower income in retirement than they have now, tax-qualified accounts usually make the most sense. That’s because you can defer taxes now with pre-tax contributions, saving money by paying taxes on your investments when you’re in a lower tax bracket, in retirement.
On the other hand, if you expect to be making more in retirement than you do now, a Roth IRA may be the best bet. Paying taxes on contributions now, while in a lower tax bracket, could pay off in retirement, when your income will be tax-free.
There’s no right answer for every situation, so be sure to discuss with your financial advisor what’s right for you.