It's really hard to save enough money for retirement -- but did you know the government will help you? That's right -- you can make pre-tax contributions to certain retirement savings accounts, such as IRAs and 401(k)s. It's the government's way of encouraging you to save for retirement so you're less likely to rely on social welfare as a senior.
But what exactly does it mean for these contributions to be pre-tax, and how does this benefit you?
What is a pre-tax retirement contribution?
A pre-tax retirement contribution is money that you put into a tax-advantaged retirement savings account -- such as a traditional IRA or 401(k) -- and that is exempt from federal income tax during the year in which you make the contribution.
If you put $10,000 into a 401(k) account, you will not pay taxes on that $10,000 in income during the year when you put the money into the 401(k). If your taxable income was $50,000 and you contributed $10,000 to your 401(k), then you would only pay taxes on $40,000 in income.
How does making a pre-tax retirement contribution benefit you?
Making pre-tax contributions to retirement accounts reduces your income tax burden for the current year. If you were in the 22% tax bracket and were able to make a $10,000 pre-tax contribution, you wouldn't pay taxes on the $10,000 -- so you'd save $2,200 ($10,000 x 22%). Your $10,000 contribution would only reduce your take-home pay by $7,800, as you would otherwise have lost that $2,200 to the IRS
That's the direct benefit. The indirect benefit is that those tax savings can enable you to contribute even more to your retirement savings, accelerating the growth of your nest egg and helping you reach your savings goals sooner.
Which retirement accounts allow pre-tax contributions?
If you want to take advantage of these generous tax benefits, there are a number of different accounts that allow you to contribute funds that are free from taxation. These tax-advantaged accounts include:
- 401(k) accounts: These are offered through employers. Certain self-employed individuals can create a Solo 401(k).
- 457 plans: Certain government employees are allowed to contribute to these accounts, and they may be able to contribute to both a 457 plan and a 401(k).
- 403(b) plans: These are similar to 401(k)s but are reserved for people in specific professions, such as nonprofit workers and those who work in education or healthcare.
- IRAs: A traditional IRA allows pre-tax contributions, and anyone with earned income can open one. Those who are self-employed can also make use of a SIMPLE IRA or SEP IRA, both of which allow for larger amounts of money to be contributed tax-free.
- Health savings accounts: While they're intended to help you save money designated for healthcare expenses, HSAs also allow you to make pre-tax contributions, leave your money invested for years, and then withdraw those funds for any purpose in retirement.
How much can you contribute to pre-tax retirement accounts?
You cannot contribute an unlimited amount of pre-tax money to tax-advantaged retirement accounts. There are annual limits. In 2018, for example, you can make a tax-deductible contribution of $18,500 to a 401(k) and $5,500 to a traditional IRA.
If you're aged 50 or older, you can make additional "catch-up" contributions. Namely, you can contribute an additional $6,000 to a 401(k) and another $1,000 to an IRA each year.
You're generally allowed to contribute to both a 401(k) and an IRA. However, if you or your spouse is covered by a retirement plan through an employer -- including a 401(k) -- there are income limits on deducting IRA contributions.
Do you ever pay taxes on money in pre-tax retirement accounts?
While contributing to tax-advantaged retirement accounts is a great deal, you don't get to escape the tax man forever.
The money in your IRA or 401(k) is taxed as ordinary income when you withdraw it. That means if you take $20,000 out of your 401(k) in retirement, you'll be taxed on that $20,000 just as if it had come from an employer. The tax rate you pay on withdrawals will be your federal income tax rate at the time of the distribution.
To make sure you don't avoid taxes forever, the IRS requires you to start taking money out starting at age 70 1/2. These mandatory withdrawals are known as required minimum distributions, and if you don't take them in full and on time, the IRS will hit you with a big penalty -- a whopping 50% of the amount of money you were supposed to withdraw.
Are there any other rules to know about pre-tax retirement accounts?
If you're contributing to pre-tax retirement accounts, it's important that you plan to leave the money invested until retirement. If you take money out of these accounts early, you may be hit with tax penalties.
Typically, you'll pay a 10% early withdrawal penalty if you take money out of your 401(k) or IRA before age 59 1/2. However, there are some exceptions if you take hardship withdrawals for qualifying purposes such as medical expenses, costs related to buying a home or preventing eviction or foreclosure, college tuition costs, funeral expenses, or certain home repair expenses.
If you qualify for a hardship withdrawal, you'll still pay taxes on the money you take out at your ordinary tax rate -- you'll just avoid the penalty associated with early withdrawal.
Should you contribute to pre-tax retirement accounts?
Contributing to tax-advantaged retirement accounts usually makes financial sense. However, you may also have the option to contribute to a Roth 401(k) or Roth IRA. Contributions to these accounts are not exempt from income taxes in the year you make them. If you contribute $10,000 to a Roth-style account, it won't reduce your taxable income at all.
However, when you withdraw your savings in retirement, you'll pay zero taxes on it. That means you'll have a reliable source of tax-free income during your senior years.
Deciding whether to contribute to pre-tax retirement accounts or Roth accounts can be complicated. There are guides to help you make this choice. Generally, if you think your tax rate now is higher than your rates will be as a senior, you may want to contribute to pre-tax accounts.
Start investing today
Saving for retirement is essential, and pre-tax accounts can help. Sign up for your 401(k) at work or open an IRA today to start saving for a more secure future.
The Motley Fool has a disclosure policy.