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What Is a Pretax Contribution?
A pretax contribution defers taxes until withdrawal, which is typically during retirement.
For example, if you set aside $10,000 of your salary to contribute to a traditional 401(k) plan in 2024, you don’t have to pay income taxes on that $10,000 of income in 2024. You will need to pay taxes on it when you withdraw funds (contributions, earnings, and any employer match) during retirement, whether that’s 2034, 2044, or 2074.
This is in contrast to both after-tax contributions and Roth contributions. Several tax-advantaged accounts allow pretax contributions, including traditional (not Roth) 401(k)s and individual retirement accounts (IRAs), as well as 403(b) and 457 plans.
Key Takeaways
- Pretax contributions are designed to encourage people to save for retirement.
- A pretax contribution is made before any taxes are paid on the amount.
- The taxes are deferred until withdrawal, which is typically retirement, except in the cases of early or hardship withdrawals.
- Pretax contributions to retirement accounts reduce your income tax burden for the current year.
Pretax vs. After-tax Contributions
If a contribution is made with income for which an individual has already paid tax, it is referred to as an after-tax contribution. This is different from pretax and Roth contributions. (See more about Roth contributions below.)
With an after-tax contribution, you deposit income into a traditional or Roth retirement account after paying taxes on it. Though there are no immediate tax breaks, the earnings on after-tax contributions grow tax deferred until they are withdrawn.
Contributions to a traditional (non-Roth) retirement savings plan can be in the form of pretax and/or after-tax contributions. (However, Roth accounts also allow for after-tax contributions.) After-tax contributions can be made instead of or in addition to pretax contributions.
This type of contribution is popular with high earners who have maxed out their 401(k) by contributing up to the limit with pretax or Roth contributions.
For tax year 2024, according to the Internal Revenue Service (IRS), if you’re younger than 50 years old, the most you can contribute to a 401(k) is $23,000. If you’re 50 or older, you can take advantage of an option to contribute an additional $7,500 in catch-up contributions.
There is a limit on contributions from all sources, including employer contributions, every year. The tax year 2024 limit is $69,000 for people under 50, with an additional $7,500 for people ages 50 and older.
After-tax and Roth contributions make sense if income tax rates are expected to be higher in the future.
Pretax vs. Roth Accounts
With a Roth account, such as a Roth 401(k) or Roth individual retirement account (IRA), you pay taxes upfront, in the year you make the contribution, so in retirement, you can withdraw the funds tax free, as long as you’ve had the account for five years (in the case of a Roth IRA) and you’re over age 59½.
If you are trying to decide whether to make pretax or Roth contributions, one strategy is to compare your current tax bracket with your expected tax bracket at retirement.
If you expect to be in a lower tax bracket at retirement, go the traditional route, and make pretax contributions. If you expect to be in a higher tax bracket at retirement, contribute to a Roth account instead. You’re aiming to withdraw funds when your income tax bracket is the lowest, to reduce the taxes you’ll need to pay.
However, you should also bear in mind that tax rules and brackets change over time. There’s no way to truly know what the future holds, so take your best guess.
Tax Savings Example
Pretax contributions lead to tax savings.
For example, consider a married employee who earns $105,000 in gross income in tax year 2024. If their effective tax rate is 20%, their tax liability for the year will be 0.20 × $105,000 = $21,000, leaving the employee with $84,000 ($105,000 – $21,000) in take-home pay.
However, if that under-50 employee maxes out their 401(k) plan with a $23,000 pretax contribution, their taxable income will be reduced to $82,000 ($105,000 – $23,000), and their tax liability will be $16,400 (0.2 × $82,000), which is a savings of $4,600 ($21,000 – $16,400).
In calculating a pretax contribution, as this example shows, the amount of taxes withheld will be reduced as the basis for the taxable amount will be reduced.
How Much Should You Invest Pretax?
Fidelity recommends that investors sock away 18% of their income on a pretax basis every year to prepare for a retirement that begins at age 67. This guideline is based on the assumption that you’ve started saving for retirement at age 30. If you’ve started at age 25, it’s 15%. For age 35, it’s 23%.
These figures include an employer match. They assume that you will have Social Security benefits and don’t have a pension, which is likely the case, given the trend away from pensions and toward 401(k)s.
Is It Better to Do Pretax or Roth?
Though it may be difficult to guess, and tax rates in the future are unknown, you should ask yourself whether you’ll be in a higher or lower income tax bracket at retirement. Will you have more taxable income then, compared to now?
If you predict that you’re going to be in a higher tax bracket at retirement, you’ll want your contributions to get taxed now. That means you’ll want to make a contribution to a Roth account. On the other hand, if you predict that you’re going to be in a lower tax bracket at retirement, you’ll want your contributions to get taxed at retirement, not now. That means you’ll want to make a pretax contribution to a traditional account.
Are Pretax Contributions Worth It?
A pretax contribution is the right move for many investors because of the tax savings. A pretax contribution reduces your taxable income, which in turn reduces the amount of taxes you pay.
You might also consider contributing to retirement via a Roth account instead. The decision to do so is largely based on whether you believe you will be in a lower tax bracket in retirement. If you do, then pretax is for you. If not, go with a Roth.
However, you should not prioritize retirement savings if you have high-interest debt, such as credit card debt, because double-digit interest rates will wipe out any tax savings you might have enjoyed.
The Bottom Line
Pretax contributions enable you to earmark funds for a retirement plan using income that has not been subject to payroll or income taxes.
Pretax contributions reduce your amount of taxable income now, which lowers your tax bill now. These taxes are deferred. You pay income tax on your contributions and earnings when you withdraw money from the account, which is typically during retirement.
If you have any questions about contributing to your retirement plan, talk to your human resources department or your plan administrator.