Here is an example of the benefit of saving on a pre-tax basis. Suppose your gross pay (before taxes) is $1,000 per week. You decide you want to save $50 per week, and you're in a 25% federal tax bracket.
If the $50 comes out of your paycheck after taxes have been taken out, you'll have $700 left. That's $1,000 (gross pay) minus $250 (taxes) minus $50 (savings). If, on the other hand, you take out the $50 before your income is taxed, you'll have $713 left. That's $1,000 (gross pay) minus $50 (savings) minus $237 (taxes). Less of your gross pay is being taxed. That's $13 more in your pocket.
To think of it another way, by using a pre-tax savings plan, you have to earn only $50 to save $50. If you were using after-tax dollars, you would have had to earn $63 to save the same amount.
Pre-Tax Savings Costs Less
Weekly gross pay
Weekly gross pay
Leveraging Your Pre-Tax Contributions
If you participate in a defined-contribution plan at your company, make sure you understand your employer's role. Your employer may be making a matching contribution.
If your employer does have a matching program (it may be 25 or 50 cents on the dollar, or more, up to a certain percentage of your contribution), make sure you are contributing at least the amount needed to receive the full match.
Here's an example: Suppose you're earning $35,000 and saving 5%, or $1,750, of your salary in your 401(k) plan. Your employer matches 50% of the first 3% of your salary that you save.
The Benefit of an Employer Match
Your 5% Pre-Tax Contribution
(50% x (3% x $35,000))
Your employer added $525 to your savings for the year. Make sure you save at least the required percentage so you don't miss out on the matching employer contribution.
SUGGESTION: A defined-contribution plan with a company match is quite difficult to beat—even by the Roth IRA.
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