How Does a Pre-Tax 401(k) Work?

Pre-tax 401(k) plans are retirement savings accounts that allow you to take money out of your paycheck before your money is taxed. Traditional 401(k) plans are pre-tax accounts, while Roth 401(k) plans have you pay taxes on the money now. When you open a pre-tax 401(k) plan, you will put money away now, and then pay taxes on it in retirement when you withdraw it.

Pre-Tax 401(k) Contributions

Your 401(k) contributions directly reduce your taxable income at the time you make them because they're typically made with pre-tax dollars. That means the money you deposit into your 401(k) comes out of your gross pay, before taxes. As a result, you pay taxes on less income.

Your take-home pay is lower than if you didn't contribute to a pre-tax 401(k) because the money reduces your gross income.

After you contribute to a pre-tax 401(k), and any other deductions are made for health insurance or life insurance, then tax withholding is calculated. These pre-tax contributions and other deductions reduce your taxable income, and you pay less tax overall on the money you earn.

You'll often find that what you contribute costs less than you expect, because of the income taxes you save.

Your contributions to a 401(k) aren't taxed until you withdraw them in retirement. Your employer can contribute to your plan as well.

Examples of Pre-Tax 401(k) Contributions

Example 1

Here's an example of how deductions from your paycheck to your 401(k) might work if you are single, live in New Jersey, and earn a salary of $45,000. You contribute 10% of your salary to a pre-tax 401(k). You have 0 allowances.

If you contribute $187 per paycheck (10%), you would take home $1,304 after taxes. This pre-tax 401(k) contribution only reduces your paycheck by $152 from what it would be if you didn't contribute. The difference between contributing $187 and bringing home an extra $152 is $35. That difference represents the pre-tax savings.

By contributing $187 per paycheck, you save $4,500 for retirement after one year. If you didn't contribute that to a pre-tax 401(k), and you used the extra $152 per paycheck and put it in a savings account for retirement, you'd have $3,648 after one year. Saving the money in a pre-tax 401(k) allows you to save more after one year.

Example 2

Here's a similar example if you were a single person making a salary of $90,000 in New Jersey. You contribute 10% of your salary to a pre-tax 401(k). You have 0 allowances.

If you contribute $375 per paycheck (10%), you would take home $2,402 after taxes. This pre-tax 401(k) contribution only reduces your paycheck by $273 from what it would be if you didn't contribute. The difference between contributing $375 and bringing home an extra $273 is $102. That difference represents the pre-tax savings.

By contributing $375 per paycheck, you save $9,000 for retirement after one year. If you didn't contribute that to a pre-tax 401(k), and you used the extra $273 per paycheck and put it in a savings account for retirement, you'd have $6,552 after one year. Saving the money in a pre-tax 401(k) allows you to save more after one year.

Example 3

Here’s another example. Let's say you're married and file jointly. You earn a salary of $100,000 and contribute 10% to a pre-tax 401(k). You have 0 allowances.

If you contribute $417 per paycheck (10%), you would take home $2,644 after taxes. This pre-tax 401(k) contribution only reduces your paycheck by $288 from what it would be if you didn't contribute. The difference between contributing $417 and bringing home an extra $288 is $129. That difference represents the pre-tax savings.

By contributing $417 per paycheck, you save $10,000 for retirement after one year. If you didn't contribute that to a pre-tax 401(k), and you used the extra $288 per paycheck and put it in a savings account for retirement, you'd have $6,912 after one year. Saving the money in a pre-tax 401(k) allows you to save more after one year.

Why Your Tax Bracket Matters

Your tax savings become more significant when you're in a higher marginal income tax bracket. That's because contributing to a 401(k), along with other pre-tax deductions, may help you reduce your gross income so much that you end up in a lower marginal tax bracket.

For example, if your gross salary is $96,000, you're in the 24% income tax bracket for tax year 2023. After pre-tax 401(k) contributions, health insurance, and other pre-tax deductions, your taxable income is now $85,000. You're now in the 22% tax bracket.

If you suspect that you'll only continue to go up in salary until you retire, contributing to a Roth 401(k) may make more sense. That's because you pay taxes on that money now, based on your tax bracket now. Come retirement, you do not have to pay tax on withdrawals. For example, if you are in the 22% tax bracket now, but could be in the 35% tax bracket later in life, a Roth account may be a good option.

Other Ways To Reduce Taxable Income

Just what you'll pay in federal income taxes is based on your taxable income. You decrease the amount of tax you pay when you reduce your taxable income.

You can use a few other financial planning strategies to reduce your taxable income. One common strategy is to set aside funds to pay for health-related expenses in a health savings account (HSA) or a flexible spending account (FSA). You might also consider paying for child care expenses with a dependent care FSA and saving for retirement in an IRA, too, which allows you to deduct contributions come tax season.

Frequently Asked Questions (FAQs)