Pre-Tax Investing and Why It’s a No Brainer

Pre-Tax InvestingGuest post by Richard Peace. Richard is a licensed Benefit Consultant (LHIC) at Financial Benefit Services managing various employer groups in the Dallas/Fort Worth Metroplex. Follow him on Twitter @richpeace.

Investors have a myriad options for socking away hard-earned cash. The overwhelming number of investment options leaves many first time investors bewildered. However, doing nothing because of the mind-boggling number of investment options is the worst investment strategy of all. Novice investors should consider pre-tax investing, which sometimes goes by the name tax deferred investments. Pre-tax investing represents the strategic investment foundation for estate and retirement planning.

Pre-Tax Investing Defined

Tax deferred investing allows you to invest money, before Uncle Sam takes his cut. You don’t pay any money as your investment accrues wealth during the lifespan of the investment. The accumulation of tax-free wealth produces higher investment returns, which makes pre-tax investing a no brainer for retirement accounts. Investors pay taxes on money withdrawn from tax-deferred accounts, rather than pay the taxman up front on income earned via weekly paychecks or capital gains.

Benefits of Pre-Tax Investing

Pre-tax investing provides three quantifiable benefits. First, investors enjoy more money to compound throughout the duration of an investment. You receive more money from tax-free investing, since the government waits until you take out money to tax your earnings. Second, your tax bracket at the time of pre-tax investing should be higher than your tax bracket after retirement. This means you pay less in taxes investing in pre-tax accounts. Pre-tax investing, such as tax-deferred retirement accounts, help investors plan to meet specific long-term financial goals such as retirement or the purchase of a small business. Finally, pre-tax investing allows you grow investment funds quicker and enjoy higher net income.

Type of Pre-Tax Investments

The deductible traditional IRA sets the standard for pre-tax investing. Investors deduct the contributions from taxable income on 1040 or 104A federal income tax forms. Early withdrawal from pre-tax IRA accounts produces substantial financial penalties. Deductible IRAs have contribution limits that change constantly. For example, the maximum deductible contribution for 2013 increased by $500 to $5,500. Qualifications for tax-deductible IRA participation include neither an investor nor spouse participating in an employer-sponsored retirement plan. Tax-deductible IRAs work great for entrepreneurs and small business owners. The federal government also sets modified gross adjust income limits for different wage earner brackets.

Employer Plans

Most employee operated 401k, 403 (b), 457, and Thrift Savings plans allow investors to invest pre-tax earnings. Employees choose how much of a paycheck goes towards one of the employer sponsored pre-tax investment plans. The amount chosen for pre-tax investing almost always involves a fixed percentage, although some recent employer plans allow employees to change contributions from paycheck to paycheck. Employers deduct the contribution, before calculating taxes. A $100 contribution to an employer sponsored pre-tax investing plan, such as a 401(k), might only decrease take home pay by only $80. For 2014, the federal government placed a $17,500 limit on all deferred compensation, including a self-employed 401(k). Workers over 50 years of age have the legal right to increase employer plan contributions by $5,500.

Pre-Tax Investing By the Numbers

Always follow the motto of carefully reviewing your personal finances AND researching tax rates, before making tax motivated investment decisions. Let’s look at two investing scenarios that involve both pre and post-tax investments. For scenario number one, you earn weekly salary of $1,000. With a 25% tax federal income tax rate, your take home declines to $750, after you give Uncle Sam his cut. Of the $750 remaining from your hard work, you decide to invest $200 of that in a savings account, which gives you $550 to pay bills and stash a little away for the monthly rent or home mortgage payment. A much more pragmatic investment strategy requires you to put the $200 post-tax savings contribution into a pre-tax investment.

Here are the numbers:

  • Weekly Gross Income: $1,000
  • 401 (k) Pre-Tax Investment: $200
  • Weekly Net Income: $800
  • Federal Income Tax Rate: 25%
  • Net Pay after Taxes: $600

By investing in a pre-tax account, you get to keep $50 more of your weekly pay and build a much larger retirement account. The $50 of extra cash per week works out to saving more than $200 every month, when you decide to select a pre-tax investment plan. Even better, many employer sponsored investment plans include an employer match that increases your pre-tax contributions.

Most financial advisors call pre-tax investing a no brainer. Yet, investors need to research all of the pre-tax investment options to select the one that matches their long-term income generating criteria. One participant in a pre-tax investment plan may opt to save money for a down payment on a home. Another pre-tax investor might choose an investment that delivers tax deferred wealth accumulation over more than 30 years to fund the retirement years.