How does saving in my plan cut my taxes?

Read time: 3 to 4 minutes

One of the best things about saving in your retirement is that saving can reduce your taxes—either today or in retirement. This article shows you how.

Pre-tax contributions let you save now and pay later

When you save pre-tax money in your retirement plan, you don’t pay taxes until you withdraw it.

Lower your taxes as you save

If you—like most retirement plan participants—make pre-tax contributions, you’re lowering your taxes while saving for retirement. The money you save in the plan doesn’t count as taxable income. So you’ll owe less in taxes as you save.

When you withdraw the money, which hopefully won’t happen until you retire, you’ll owe regular federal, state, and local income taxes on your contributions and any earnings.

CAUTION

If you withdraw any pre-tax money before age 59½, you’ll owe a 10% federal tax penalty in addition to your regular taxes unless an exception applies.

Have a happier paycheck

Remember your first real paycheck? Wasn’t it kind of a bummer to see your pay reduced by all those withholdings that you had never heard of before? Pre-tax contributions soften some of those hits.

Your pre-tax contributions are deducted from your income before federal taxes are withheld. This means that the amount of taxes taken out of your paycheck goes down.

Roth contributions let you pay now and save later

If your plan allows Roth after-tax contributions, you have a second way to save on taxes. You can pay taxes on your contributions now but take tax-free withdrawals in retirement.

How Roth works

More and more retirement plans offer Roth contributions. If yours does (check your plan rules), you can get tax-free income in retirement.

You make Roth contributions with after-tax money, so you don’t get a tax break as you save. But withdrawals of both contributions and any earnings are tax-free if you meet certain conditions.

What are the conditions?

There are two. You must meet both to qualify for tax-free withdrawals.

You must be age 59½ or older when you withdraw the Roth earnings.
You must have made your first Roth contribution at least five years before withdrawing your Roth earnings.

CAUTION

If you don’t meet both requirements for a tax-free withdrawal, any earnings you withdraw are taxed at your regular federal, state, and local rates. You may also owe a 10% federal tax penalty.

Pick your tax break

If your retirement plan offers both pre-tax and Roth contributions, you can decide whether to lower your taxes now or in retirement. Which one makes more sense for you?

Pre-tax might be better if …

You’re behind on saving and expect Social Security to be the mainstay of your retirement income.
Your pay spikes from time to time because of commissions or bonuses.
You have a family and receive certain tax credits such as the earned income tax credit.

Roth might be better if …

You’re well-prepared for retirement, with strong savings and benefits.
You contribute the maximum allowed to your plan.
You pay taxes at a low rate today (10% or 12%).

Note: We mean "better" in the sense that you’ll probably end up paying less in taxes over the course of your lifetime. That may not necessarily be your personal priority today. For some, the benefit of a tax deduction today outweighs the prospect of a tax break in the future.

You can contribute both ways

For most people, it’s tough to be sure whether pre-tax or Roth contributions will save you more in the long run. The good news is, you can make both.

Splitting your contributions between pre-tax and Roth guarantees that at least some of your savings will receive the best tax advantage available to you.

Whenever you invest there's a chance you could lose money. Diversification does not ensure a profit or protect against a loss.