This day and age, conscientious use of 401 (k)s and other retirement accounts is essential if you want the retirement of your dreams, but why is this the case? Do they offer some sort of notable benefit over a typical savings account?
Well, the obvious advantage of using this sort of retirement account is that your employer is obliged to add to them in tandem with you, essentially offering you free money, but this isn’t the only reason these accounts are so critical.
Could another be that 401 (k) contributions are amassed, pre tax? Well, that’s exactly what I’m going to be discussing with you today! Let’s dive right in.
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401 (K) Accounts: Pre Or Post Tax?
You’ll be happy to hear that 401 (k) retirement savings accounts are indeed classified as pre tax entities, adding yet another financial feather to the 401 (k)’s cap.
This, alongside a few other beneficial factors, is why the 401 (k) plan is so popular among the general population.
With one of these accounts steadily accruing funds, you set yourself up with a pretty sweet nest egg for the day you pack in your professional life for good and enjoy some you time.
What Does It Mean If An Account Is “Pre Tax”?
With our key question answered, let’s briefly examine what exactly “pre tax” means in this context. The term obviously implies something happens before taxation is implemented, but what exactly is this untaxed entity?
The entity (or entities, I should say) are the contributions you’re making to the account in question.
In a nutshell, a pre tax account means that any contributions you make to this account during the accumulation period, i.e. before you retire, will not be taxed… yet. These contributions are known as pre-tax dollars.
When Will A Pre Tax Account Be Taxed?
A pre tax retirement savings account will only incur taxation once you withdraw your money, and, with a 401 (k), you can do so without paying an early withdrawal fee when you reach the age of 59 & ½.
Once the money is withdrawn into another account, it will be taxed in the same manner as any other funds you may have accumulated in traditional savings or long-term savings accounts.
Why Is A Pre Tax Account Helpful?
Okay, so we’ve established that a pre tax account means the money within will not be taxed until withdrawn, but what’s the point? If it’s going to be taxed eventually, why delay the inevitable?
Well, every year that money accumulates without being taxed, you’re saving a significant sum of money — It’s completely untouchable for your entire working life.
Yes, you’ll be taxed on the full amount once withdrawn, but by then you’ve likely enjoyed 40+ tax-free years.
The same temporary tax exemption applies to any form of contribution to the account.
For example, the building interest, capital gains, and dividends will also be free from tax until the day you withdraw the funds, but this is just the tip of the 401 (k) iceberg!
For each pre-tax dollar that you funnel into your 401 (k), your taxable income is reduced in kind, and even though this means your liquid income also goes down, it decreases by a lesser degree, leading to some substantial gains over the years.
What About The Roth 401 (K)?
The Roth 401 (k) is gaining popularity as an alternative to the traditional 401 (k) format, and although the key principles of both accounts are aligned, there is one major difference to mention.
Your contributions to a Roth 401 (k) are never pre tax as they would be with a standard 401 (k). Instead, they are post (or after) tax contributions, meaning the money you place in your account has already been taxed as if it were heading into your current account like your normal salary.
The plus side of this format is that the cash and any interest accrued over the years will not be taxed again once withdrawn, which is certainly something to look forward to.
Employer Matches & The Roth 401 (K)
The best thing about traditional 401 (k)s is that your employer is obliged to match your own contributions, which can really add up over time, especially if you max out your contributions.
Employers can do the same with an employee’s Roth 401 (k); however, the IRS does not allow for post tax matches. The financial institution stipulates that all employer matches must be pre-tax dollars.
This means that any matches will be directed to a separate but connected Roth 401 (k) account, and they will not be taxed until withdrawn.
Is My 401 (K) Enough For My Retirement?
401 (k)s are a fantastic place to start preparing for your retirement, but most would consider them just that… a start.
Of course, the funds you’ll need when you clock out for good will be determined by the sort of post-work life you want to lead, but the general consensus is that you should be pairing your 401 (k) with other nest eggs to ensure you’re taken care of later in life.
The absolute best thing you can do to boost the impact of your 401 (k), whether it follows the traditional or Roth format, is to ask your employer’s HR department what the maximum match is and then meet that threshold every month.
You’ll have a slightly smaller paycheck, but it’s an important investment in your future.
Steadfast security in the autumn of your life may require additional shrewd financial planning. Many choose to invest in various assets, while others combine multiple saving methods to optimize their eventual gains.
Final Thoughts
Yep, the traditional 401 (k) is a pre tax account, meaning that all your contributions (as well as your employer’s) are pre tax too, meaning you won’t be taxed until you withdraw it, ideally after you reach the age of 59.5.
Roth 401 (k)s are slightly different in that they’re not a pre tax account, but, in accordance with IRS rules, any employer matches will be pre tax, and therefore, will be taxed upon withdrawal.
