What exactly does “pre-tax savings” mean?
Yes, it’s about saving money from your income prior to income tax being assessed—and this is a tax strategy that many people use—but people using this approach do not always understand how it works. In this 4-minute video, we explain this strategy, so you can keep your money working for you as you create your life of financial freedom.
Full Transcript of video
Hello, I’m Josh Duncan with SCB News bringing you this edition of Financial Freedom. The purpose of Financial Freedom is to provide tips to help you achieve financial freedom for personal significance.
Even though tax season has come to an end, that doesn’t mean we should stop thinking about taxes. I know, I know, this is not the most popular topic with many Americans. However, taxes are a reality we all must face. Therefore, let’s discuss a strategy to keep your money working for you.
The main point of discussion today is pre-tax savings; saving money from your income prior to income tax being assessed. This is a tax strategy many people use. But those using the strategy do not always understand how it works.
Let’s assume you have access, through your employer, to a pre-tax retirement savings plan, such as a 401(k), 403(b), 457, or SIMPLE IRA. Typically, you choose a percentage of your gross income to add to your plan. With every paycheck, this percentage is taken from your gross pay and added to your plan. If you make $100,000 per year and you contribute 4% to your plan, a total of $4,000 per year is added to your plan. This is $4,000 you will not pay income tax on, this year. Note that payroll tax of 6.2% for Social Security, Medicare, and unemployment still must be paid. Your employer pays 6.2% as well.
So, you just successfully removed $4,000 from your taxable income while keeping the money in your name and investing it for growth in your retirement plan! How much did you save on taxes? This depends on your tax bracket. If you are married with $100,000 of taxable income, you are in the 22% tax bracket for 2019. 22% of $4,000 gives you an $880 savings today.
Let’s be clear that you have not avoided paying taxes. You have simply deferred paying taxes until you remove the money from your retirement account. However, this money is taxed as regular income, just like your pay from your employer. The idea is that you will be in a lower tax bracket when you are retired because you will not have income from an employer. Therefore, the tax rate you pay could be less when you are retired. This is the theory but could be changed by legislation at any time.
Let’s take this a step further. There are limits on the amount you can contribute to these plans each year. In 2019 the limit is $19,000 to a 401(k) for those of you younger than 50. If you are 50 or older, you can contribute an additional $6,000. That is a total of $25,000 of taxable income you can defer for retirement. Using the same example as before, 22% of $25,000 gives you a $5,500 tax savings this year! Note that each type of plan has its own rules so be sure to review yours.
This is one of many ways to use retirement accounts in your tax strategy. This may not be the best strategy for everyone. However, if you are in a higher tax bracket, using a pre-tax retirement account could prove beneficial for your tax plan.
As always, it’s best to work with a trusted financial advisor or tax planner if you are not comfortable building your tax plan on your own.
Thank you for joining me for Financial Freedom. I'm Josh Duncan, Financial Advisor with F5 Financial Planning, helping you achieve financial freedom for personal significance Please contact me here to send topics you would like me to cover. See you next time.
Photo credit: SCB Video TV Marketing (producers of the video)
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