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What Does It Mean to Be Pre-Tax or Tax-Advantaged?

By FINRA Staff - Mar 9, 2018 at 6:33PM

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They both involve saving money, so you should get to know these terms.

The taxman cometh, and that may have you wondering: What does it mean for something to be pre-tax or tax-advantaged?

From commuter and child care benefits to retirement accounts, pre-tax benefits and tax-advantaged accounts offer some sort of tax benefit, whether that means contributions are tax-deferred or tax-free. Either way, this could mean more money in your pocket at the end of the tax year.

The phrases "tax-advantaged" and "pre-tax" are often used interchangeably, and there are two categories to which these phrases generally apply: benefits and retirement contributions. Let's take a look at them each in turn.

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Image source: Getty Images.

Pre-tax benefits

Pre-tax benefits are employer-provided fringe benefits that are tax-free. These benefits are known as "pre-tax" because they are subtracted from your paycheck before your taxes are calculated.

Common tax-free benefits can include:

  • Health benefits (insurance premiums, HSA/FSA contributions)
  • Long-term care insurance
  • Term-life insurance
  • Disability insurance
  • Educational assistance
  • Dependent care assistance
  • Commuter benefits

Every dollar paid toward a pre-tax benefit reduces your current taxable income by an equal amount, which means you will owe less in income taxes for the year.

Here's how that works. Say you earn $40,000 but contribute $1,600 to your flexible spending account (FSA) to put toward qualified healthcare expenses. If you looked at just that one pre-tax expense, you'd find that you now only owe taxes on $38,400, rather than $40,000.

If you're single, your total federal tax bill using the 2017 IRS tax rate schedule and a standard deduction would be $4,345 instead of $4,585 -- a tax savings of $240. You can see how taking advantage of multiple pre-tax benefits could add up.

It is worth noting, however, that your ability to contribute to these pre-tax benefit accounts will vary by employer, and there are federal limits on how much you can contribute to different accounts in a tax year.

Tax-advantaged retirement contributions

The other area where you will often see the phrases "pre-tax" or "tax-advantaged" thrown around is when it comes to retirement savings.

Retirements savings accounts -- including 401(k) plans, 403(b) plans, 457 plans and, in some cases, traditional IRAs -- allow you to save for retirement on a tax-deferred basis. That means contributions to these accounts are made on a pre-tax basis, and you won't pay taxes on that money or on its earnings (including interest, dividends, and capital gains) until you withdraw from your account, usually after you retire.

The tax you eventually pay depends on your income tax rate at the time of the withdrawal. Most people have less income in retirement than they did when they were working, and thus can expect to pay these deferred taxes at a lower rate -- assuming, of course, that tax rates remain the same.

To continue with the previous example, if you earn $40,000 but contribute $1,600 to your FSA and an additional $6,000 to your traditional 401(k), you would find that you owe taxes on only $32,400 at the end of the year.

If you're single, your total federal tax bill using the 2017 IRS tax rate schedule and a standard deduction would be $3,438 instead of $4,585 -- a tax savings of $1,147.

One more thing: Though contributions to a Roth 401(k) or Roth IRA are not deducted from your income pre-tax, contributions are tax-advantaged. The advantage in the case of a Roth is that withdrawals are completely tax-free, provided the account is open at least five years and you are at least 59 1/2 years of age.

It is too late to make 401(k) contributions for the 2017 tax year to benefit from these advantages, but it isn't too late to take advantage of some other pre-tax benefits. You have until Tuesday, April 17, this year to contribute to an IRA (whether or not the contribution is tax-advantaged), health savings account (HSA), or self-employed retirement accounts for the 2017 tax year.

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