Your employer may allow you to cover some ongoing expenses with pretax dollars.
Pretax dollars are funds that are taken from your pay before certain taxes on your pay are calculated (for example, your federal income tax). Your taxes are then calculated on your remaining pay, and this creates a tax savings for you. For example, if you are in a flat 25% tax bracket and you’re allowed to buy a $100 commuter pass with pretax dollars, the pass really only costs you $75 in after-tax (or take-home pay) dollars.
The result can be a lower out-of-pocket expense for you.
Some opportunities (if your employer offers them) where you might cover expenses with pretax dollars may include paying your health insurance, disability insurance, dental insurance, and vision insurance premiums. Your employer may also allow you to contribute pretax dollars to a “flexible spending account” (FSA) for either medical expenses or dependent care expenses. With an FSA, you contribute pretax earnings to the plan and submit qualifying expenses to the plan for reimbursement. And, as mentioned above in our example, your employer may allow you to pay certain qualified commuter or parking expenses with pretax dollars.
Your employer may also offer a retirement plan like a 401(k) plan, a 403(b) plan, or a 457(b) plan. What these plans have in common is that they allow you to elect to contribute a percentage of your earnings on a pretax basis. These plans are intended to be used to save for retirement, and they offer advantages that go well beyond the fact that you get to fund them with pretax dollars.
Another tax consideration is that some specific investment vehicles allow for tax-deferred growth. Whether you’re investing pretax or after-tax dollars, tax-deferred growth basically means that you won’t owe any taxes on the growth of that investment until you withdraw funds from the account. In certain cases, qualified withdrawals from these investment vehicles may be tax free.
Some examples of investment vehicles that qualify for tax-deferred growth are 529 college savings plans and prepaid tuition plans. A 529 plan is funded with after-tax dollars. Your investment grows tax deferred until you withdraw the funds; at that time, if the funds are used for qualified educational expenses, the funds may be withdrawn tax free.
Both traditional and Roth IRAs also allow tax-deferred growth. In the case of traditional IRAs, your contributions are made with after-tax dollars, but they may—if you qualify—be tax deductible on your federal income tax return. This is important because tax-deductible contributions lower your taxable income for the year, saving you money. And funds in a traditional IRA are sheltered from federal income tax until withdrawn. As for Roth IRAs, if you qualify on the basis of your income to contribute to one, your contributions are made with after-tax dollars and aren’t tax deductible. But the good news is that, if you meet certain conditions, your withdrawals from a Roth IRA, including any investment earnings, will be completely free from federal income tax.
With most of the investment vehicles mentioned, for example 401(k) plans, IRAs, and 529 plans, a 10% penalty tax applies if you take distributions before a certain age or for a non-qualifying purpose.
Let’s illustrate the value of tax deferral.
Let’s assume you have $20,000 to invest. You put $10,000 into a taxable account that earns 6% per year, and use a portion of these assets each year to pay taxes attributable to the account’s earnings. You put the other $10,000 into a tax-deferred account that also earns 6% per year.
Assuming that a 28% tax rate applies, in 30 years your taxable account will be worth about $35,500.
In the same amount of time, your tax-deferred account will have almost $57,000. That’s a difference of over $21,000.
Of course, the funds in the tax-deferred account might be subject to federal income tax when withdrawn. But even if you took the entire amount in the tax-deferred account as a lump-sum distribution after 30 years and paid tax on the full amount, you would still come out ahead in this example (at 28% tax, you’d end up with a little over $41,000). Again, a note of caution—depending on the specific tax-deferred vehicle, an additional 10% penalty tax could apply if you took distributions before a certain age or for a non-qualified purpose. Additionally, the illustration assumes a fixed annual rate of return over the 30-year period. Of course, in real life, the return on a portfolio will vary over time according to market conditions—this is particularly true for long-term investments.
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