Pre-tax contribution is the amount of deductions you make from your monthly gross wage into your 401k retirement savings account, BEFORE taxes have been deducted. By making pre-tax contributions, you are lowering your current taxable income. For example, if you earn $10,000 per month, and contribute 10% of it towards a 401k retirement savings account, then your current taxable income is lowered to 90% x $10,000 = $9000. Instead of paying taxes on the $10,000, you will be paying taxes only on the $9000!
Another example is if you make $50,000 a year GROSS wage and contribute 10% of it into your 401k account, your current taxable income will be $50,000 – (10% x 50,000) = $45,000
On the other hand, after-tax contributions are the amount of deductions you make from your monthly income AFTER taxes have been paid. A scenario would be if you make $50,000 a year and pay $13000 in taxes, your net annual income would be $37,000. From this $37000 net income, you could make a contribution of $10,000 into a 401k plan. Your after-tax 401k contributions are therefore $10,000.
Here’s a summary of the differences between pre-tax and after-tax 401k contributions in a tabular format:
|– Deducted from your gross wage before taxes
– Lowers your current taxable income so you pay less taxes now
– Is taxed as ordinary income when you withdraw 401k retirement savings
– Lots of restrictions: You cannot withdraw before the age of 59.5. If you do, you’ll pay 10% early withdrawal penalty fee as well as local and federal state taxes
|– Deducted from your net wage after taxes
– Is deducted after you pay taxes, so your current taxable income is NOT lowered
– Don’t have to pay tax on withdrawals because you’ve already paid taxes – Any earnings you make however are taxable just as ordinary income
– Less restrictions on withdrawing income before the age of 59.5.
– For example, if you withdrew $5000 on which you earned $450 interest, you will not be taxed on the $5000. However, you WILL be taxed on the $450.
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