Pre-tax versus After-tax
401(k) and IRA Contributions
(August 27th, 2009)
Pre-tax 401k contributions are any contributions
made to a 401k account from your bi-weekly gross income before any
taxes are deducted. By making 401k contributions, you are getting
a tax benefit now because you are lowering your current taxable
income. For instance, if you earn $6,500 a month gross wage and
contribute 15% of this to your employer sponsored 401(k) plan, this
monthly taxable income before making 401(k) contributions
contributed amounts =
($6,500 x 15%)
current lowered taxable income =
This is one of the main advantages of contributing
to a 401k plan on a pre-tax basis; the fact that you can get an
instant deduction on your income tax return. Thus, instead of paying
taxes on your $6,500 wages every month, you will be taxed on $5,525
only! Nice isn’t it?
Another useful example is say you
earn $75,000 a year gross wage and contribute 15% of this to your
employer sponsored 401k plan. Note your total taxable income will
Gross Income =
annual contributions =
x 15% = $11,250
- $11,250 = $63,750
On the other hand, after-tax 401k contributions
are contributions that you make to your retirement plan after you
have paid taxes. For instance, consider you earn $75,000 this year
and are in the 25% tax bracket. Here is how your calculations would
Gross Income =
- $18,750 = $56,250
Contributions (15%) =
x 15% = $8,437.50
From these calculations, you see that you
are making a contribution of $8,437.50 on a net income of $56,250
after you have taken care of the taxes. What this means is that
when you retire and turn 65 years old, you will be able to withdraw
this $8,437.50 plus investment gains on it without having to pay
taxes again. This is one of the main advantages of contributing
on an after-tax basis; you take care of the taxes now and do not
have to worry about them upon retirement.
Summary of Differences between Pre-tax and After-tax 401(k) Contributions
- Contributions made from your
gross income before taxes are paid.
- Lowered current taxable income as you receive a deduction
- Taxed as ordinary income upon withdrawal when you turn
65 years or upon retirement.
- Any withdrawals made before the age of 59 and ½
are subject to a 10% early withdrawal penalty and taxes.
- Contributions are made from your net income
after you have paid taxes now.
- Your current taxable income is not lowered because you
make contributions after having paid taxes.
- When you retire at 65, you will not be taxed during that
time. Any earnings you have made on these contributions will
be taxable as ordinary income upon withdrawal. For example,
say you contributed $10,000 after paying taxes, and earned
10% on this contribution totalling $1000.
- Upon retirement when you make the withdrawal, you will
be taxed in the ordinary tax bracket for $1000 and your $10,000
will not be taxed because you have already paid taxes on it
once (before making the contribution).
- After-tax 401k contributions can be withdrawn if you meet
any hardship withdrawal requirements.