The Power of Pre-Tax Retirement Account Contributions

The power of tax-deferral is an important benefit offered by many retirement savings programs such as §403(b), §401(k) and §457 plans, SIMPLE and SEP-IRAs, and traditional IRAs.¹

When contributions are made on a pre-tax basis, your current taxable income is reduced by the amount you invest. Just as important, taxes on any earnings your tax-deferred investments generate are deferred as well, putting more of your money to work for you over time. Taxes are not due until you begin to make withdrawals—usually at retirement—which may be years away.² Plus, while distributions are taxed as ordinary income, the impact may be minimized as many investors find themselves in a lower tax bracket at retirement.

The following illustration depicts the advantages of pre-tax contributions within a pre-tax retirement savings account.

Ellen and Greg both earn $3,000 per month, and both save $250 each month towards their retirement. However, Ellen has the opportunity to invest in a retirement plan on a pre-tax basis, while Greg’s contributions are made to an after-tax savings program.

Since Greg’s investments are not tax-deferred, he will have $3,000 of taxable income for the month. Under current income tax rates, approximately $572 would go to the federal government and FICA would be about another $230. As Greg is saving $250 a month for retirement, he would be left with $1,948 in spendable income.

Since Ellen contributes $250 to a tax-deferred retirement savings plan, her taxable income is only $2,750. As such, her taxes will be less than Greg’s with about $412 going to the federal government and FICA remaining at $230. Since Ellen has reduced her taxable income by contributing to a pre-tax retirement plan, her spendable income is $2,108.

As you can see, even though Ellen and Greg are each saving the same amount for retirement, Ellen is able to take home $160 more dollars per pay period because she is investing on a pre-tax basis.