Contributions to your employer-sponsored retirement plan are traditionally made pre-tax, unless your plan offers a Roth option, which we will discuss another time.
Pre-tax contributions are kind of a big deal. They truly are the gift - in the little blue box - that keeps on giving. First, let’s say you make $80,000 a year from your super fab job. Normally, you would be taxed on your entire $80k because the IRS wants their money. However, if you made a $10,000 pre-tax contribution to your retirement plan, you would only be taxed on $70,000 of income ($80,000 income - $10,000 annual pre-tax contribution = $70,000 of taxable income).
In addition to the tax benefit in the year you make the contribution, your money grows tax-deferred, hopefully until you are ready to withdraw it when needed at retirement.
Tax-deferred savings is legit. Take a look at our example with Vickie and Stan below.
VICKIE
- Saves $2,000 per year
- Starts at age 25
- Continues for 40 years
- Invests in a tax-deferred account and earns a 9% pre-tax return
STAN
- Saves $2,000 per year
- Starts at age 25
- Continues for 40 years
- Invests in a taxable account and earns a 9% pre-tax and 6.7% after-tax return
Here’s what they would both have at age 65: