Financial advisors and other financial professionals throw around certain terms like, pre-tax dollars, like everyone already knows what they mean. In some cases, they are right, and in other cases, most people only have a partial grasp on what exactly certain financial terms mean. In many cases, knowing the complete definition of a word or phrase makes all the difference.
What Does Pre-Tax Mean?
Pre-tax dollars is a phrase that is often used in conjunction with retirement planning and 401k contributions. In fact, one of the benefits of a 401k plan is that contributions are made with pre-tax dollars. But, what is the definition of pre-tax dollars, anyway?
When an employee gets paid, there are numerous deductions that get taken out of their paycheck. These payroll deductions range from income tax withholding to FICA taxes to voluntary contributions for things like health insurance or cafeteria plans (Section 125 plans).
Some of the deductions from your paycheck, like federal tax withholding, are computed based on how much you are paid. Pre-tax means that the deduction occurs before that withholding is calculated. This is why many financial writers and other financial experts point out that contributing to your 401k plan doesn’t actually reduce your paycheck by the full amount.
It is worth noting that both Medicare taxes and Social Security taxes are not reduced by pre-tax contributions to your 401k. That is why there is separate entry for FICA Wages or Social Security Wages on your paystub or W2 Form.
How Pre-Tax Contributions Affect Your Taxes
The impact of pre-tax contributions on your taxes goes beyond just how it changes calculations on your paycheck. Pre-tax 401k deferrals are also not included in the taxable wages reported on Form W-2.
W-2 wages are used as the starting point for calculating your Adjusted Gross Income and Modified Adjusted Gross Income (MAGI). These two numbers form the basis of your taxable income. Just as importantly, these numbers also determine your eligibility for numerous tax deductions and tax credits, as well eligibility for tax items with income limits.
For example, contributing to your 401k reduces the your income for purposes of determining whether an IRA contribution is deductible or whether you meet the income limits for Roth IRA contributions. It also can affect which tax bracket you are in. Contribute enough to your 401k to drop your income under the bottom of the tax bracket and you’ll pay taxes in the lower bracket only.
401k Contributions and Advanced Tax Planning
Unlike IRA contributions which can be made until April 15th of the following tax year, 401k contributions have to be during the tax year (before December 31st). 401k contributions also have to be made via salary withholding which means you can’t just write a $10,000 check at the end of the year to bump up your 401k contributions to the right level.
In order to specifically target an income level or total wages, you’ll need some advance tax planning. Calculate the ballpark withholding you think you’ll need at the beginning of the year and notify your employer. Then, over the course of the year monitor your 401k withholding and wages to see if they are tracking to the target you have. Adjust your 401k contributions during the summer and again in October. That means only subtle shifts should be necessary (if at all) in the last couple months of the year.