The concept of pretax contributions might seem complicated but it essentially refers to the funds you invest into specific types of retirement accounts before income tax is withdrawn. This strategy provides immediate tax gains by reducing your taxable income for the year and becomes quite beneficial if you’re trying to delay your potential tax liability. If you’re not sure how to implement this strategy or even if it makes sense for you, consider working with a financial advisor.
How Pretax Contributions Work
Getting a good grasp of pretax contributions requires an understanding of key retirement savings accounts like 401(k) plans and traditional individual retirement accounts (IRAs). These are potential examples of investment accounts that are considered tax-advantaged accounts because you get to invest money that hasn’t been taxed yet.
This drop in taxable income can translate into sizable tax savings. The more you contribute, the lesser your taxable income becomes, and consequently, the lower the tax you owe. It’s a simple yet powerful strategy for retirement savings while abating your current tax liability.
For instance, if you contributed $19,500 into a traditional 401(k), that sum could be deducted from your paycheck before taxes come into play, reducing your taxable earnings for the year and also giving you tax benefits as those funds grow. For example, if your annual earnings amounted to $100,000 and you contributed $19,500 to a pretax retirement account, your taxable income for that year decreases to $81,500.
Even though you will pay taxes when you withdraw the funds later, the general expectation is that you’ll be in a lower tax bracket by then, resulting in an overall tax savings. Also, as a part of your retirement planning strategy, consider asking your advisor about tax diversification for a more balanced approach to your financial future.
What Is a Tax-Advantaged Account?
A tax-advantaged account is a type of savings or investment account that comes with certain tax benefits, primarily the advantages of contributing pretax dollars and deferred taxes on earnings and growth. Plus, other tax-advantaged accounts may have more or different advantages than just the ability to add pre-tax dollars.
Each of these accounts carries its own set of benefits and rules. For example, HSAs are available for those with qualified high-deductible health plans and can be leveraged to pay for sanctioned medical expenses tax-free. Contrarily, Roth IRAs offer tax-free growth and withdrawals in retirement, while 529 plans permit tax-free savings growth when used for education costs.
After-Tax Contribution Plans
Contrasting with pretax contribution plans are after-tax contribution accounts like Roth IRAs and Roth 401(k)s. With these plans, you contribute after-tax dollars, but the money grows tax-free and is still tax-free when you retire, no matter how much the money has grown, as long as you make proper withdrawals.
Ultimately, this could prove beneficial if a higher tax bracket awaits you in retirement, as your withdrawals won’t be subjected to taxes. But it’s essential to understand that these contributions don’t decrease your current taxable income, so you won’t see an immediate tax break. Also, while many financial advisors suggest the potential future value of these plans, it’s relevant to navigate this space with professional advice and it will depend heavily on the your financial situation.
Tips for Reducing Your Tax Burden This Year
Strategically leveraging pretax contributions can help pare down your tax burden this year but it’s not the only thing you can do. You might want to think about cranking up your pretax contributions to your retirement plan. Here are some other things you might want to consider if you’re trying to limit your tax burden.
- Invest in municipal bonds: Buying a municipal bond means lending money to state and local governments for a set number of interest payments. Interest on these bonds are exempt from federal taxes.
- Open an HSA: If you can open a health savings account, as mentioned above, you could put some of your taxable income in that account. This is helpful if you would be spending money on health expenses anyway.
- Consider tax credits: You might be able to qualify for tax credits that you didn’t know existed. Consider talking to a financial advisor or tax professional about what credits you might qualify for.
- Open a 529 plan: If you’re planning to save money for your child’s education anyway, then you can do it in a tax-advantaged 529 account.
Bottom Line
Understanding and strategically employing pretax contributions can be a potent way to dull your tax blade and bolster your retirement savings. By closely examining different types of contribution plans and assessing your current and future tax scenario, you can make informed decisions that underpin your long-term financial health. But bear in mind, every financial situation is individually unique and while pretax contributions offer substantial benefits, they might not always be the best strategy for everyone.
Tips for Tax Planning
- Investing is hard enough when you’re just trying to figure out the right asset mix, but it becomes even more difficult when you think about potential tax consequences. That’s where a professional financial advisor comes in. They can help you create a good investment plan that helps save on taxes. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you’re worried about what your tax obligations might be, consider using SmartAsset’s free income tax calculator.
Photo credit: ©iStock.com/Goodboy Picture Company, ©iStock.com/Marvin Samuel Tolentino Pineda, ©iStock.com/shapecharge