Reduce Your Current Income Tax

If you could take a portion of the money you'd ordinarily pay to the government in income taxes, and pay it to yourself instead, would you do it?

Of course you would. Basically, that's what happens when you contribute to your retirement savings plan on a before-tax basis.

Before-tax contributions give you a nice tax break.

With before-tax contributions, every dollar you contribute to the plan lowers your federal taxable income by a dollar (up to the $15,500 maximum allowed by law for 2008). Reducing your taxable income means writing a smaller check to the IRS. It's just that simple.

Of course, your tax liability doesn't just go away forever (you didn't think Uncle Sam was that nice, did you?). You're merely postponing the taxation of your money. You'll eventually owe taxes on your before-tax contributions and earnings when you withdraw the money. But most likely that will be at retirement, when you may be in a lower tax bracket because you will no longer be working full-time and may not be earning the level of income you are today.

Here's how before-tax contributions work:

Let's say you make $25,000 a year. You choose to contribute 6% of your pay on a before-tax basis. That means you're putting $1,500 a year into the plan. This lowers your taxable income to $23,500. The result is your income tax bill is lower than it would have been if you hadn't contributed to the plan. You're keeping for yourself some of the money you would have paid in taxes. Makes sense, right?

Here's how the actual tax savings works out:

Before-tax contributions give you a nice tax break. And the money will grow tax-deferred while it's invested in the plan. So what's the catch? Well, since this money is earmarked for retirement, you usually can't withdraw it before age 59 1/2 without getting hit with a 10% early withdrawal penalty plus your tax liability.

After-tax contributions give you withdrawal flexibility

Your employer's plan also may allow you to contribute on an after-tax basis, which means you're putting money into the plan after your taxes have been paid. That's why after-tax contributions do not lower your current taxes the way before-tax contributions do.

The benefit of after-tax contributions is that you can withdraw those contributions anytime (you should review your plan features for specific rules for your plan). But here's an important distinction: Even though you've already paid taxes on your after-tax contributions, any earnings you get on those contributions are growing tax-deferred inside the plan. If you withdraw after-tax contributions, you may be required to withdraw a portion of the earnings on those contributions. The earnings portion will be treated just like a before-tax withdrawal, which means it may be subject to early withdrawal penalties in addition to taxes.

Before-tax or after-tax? That is the question

When you save in a bank or credit union account, or a brokerage account, you're saving money after you've paid taxes on it. The advantage of this after-tax savings is you can withdraw the money anytime for any reason without paying penalties. For most people, the tax break offered by before-tax saving outweighs the flexibility of being able to withdraw after-tax savings anytime-at least for long-term retirement savings. With a retirement savings program, if you withdraw your money early, it's like siphoning gas out of your tank after you've started out on a cross-country sightseeing trip. You won't get very far on fumes alone!

Your plan may offer before-tax contributions, after-tax contributions, or both. If your plan offers both, generally, you should maximize your pre-tax savings because of the tax deferral and employer matching benefits before making after-tax contributions.