Pre-tax contributions for a 401(k) plan refer to the money that is invested into the retirement plan before any taxes are applied to the individual’s income. Here’s how it works:
- Contribution: The employee elects to defer a portion of their salary into their 401(k) plan.
- Tax Treatment: This deferred salary does not count as taxable income in the year it is earned, meaning the employee does not pay income tax on the amount contributed that year.
- Tax Deferral: The contributions and any investment gains grow tax-deferred, meaning no taxes are paid while the money remains in the account.
- Taxation Upon Withdrawal: Taxes are paid on these contributions and on the investment gains when the money is withdrawn from the plan, typically after the individual has reached retirement age. At this point, the individual may be in a lower tax bracket than they were during their working years, potentially paying less in taxes overall.
Pre-tax contributions can reduce an individual’s taxable income, which may decrease their current income tax liability. However, because these contributions are made before taxes are taken out, they are subject to income tax when the money is withdrawn.