Q:  My employer offers several “pre-tax” investing options.  I have considered enrolling in one, but was curious if they are really worth all the hype people make about them?

A:   When it comes to investing, there is no such thing as “is it worth it.”  There are few things in life that will provide you with a greater benefit than investing in your financial future.  Having a sizeable and secure asset base allows for many things.  Some of these include peace of mind, reduced anxiety, freedom as well as the knowledge that you will be provided for in the future.  There is no worse feeling than having the desire to do something but not being able to because of financial limitations.  So when it comes time to retire, you don’t want to be forced to prolong the daily grind because you don’t have enough cash.

 The current tax law encourages making certain investments on a pre-tax basis.  Some of these investments include 401(k) plans, deductible IRAs and SIMPLE plans; all of which are funded through payroll withholding arrangements.  Yet many people fail to take full advantage of these investment vehicles for various reasons. 

 Investing money on a pre-tax basis has two major benefits that tend to be overlooked.  These include becoming a disciplined saver and investing a greater amount of money when compared to investing on an after-tax basis.  When individuals enroll in any of the programs named above, the amount they stipulate to be invested is automatically withheld from their paycheck.  Therefore, the participant doesn’t have to remember to make a contribution because it’s done automatically.  This is especially beneficial for those who tend to procrastinate or let money burn a hole through their pockets.  Plus, the individual tends to not miss the deducted funds because they never see the money.

Where the true benefit can be seen is in the differential between the amounts available to invest, as well as the return on investment.  Let’s say, for example, an individual contributes $11,000 of their gross wages to their company 401(k) plan through payroll deductions.  This amount will not have federal or state taxes withheld when the contributions are made.  Also, when they receive their W-2 form around January of the next year, this amount will not be included as income.  Consequently the tax liability calculated on their income tax return will be lower because the income base will be smaller.

 The employee will also benefit from their pre-tax investment with regards to growth.  Because their $11,000 was not reduced by tax withholdings, it is larger when compared to an after-tax equivalent.  This larger amount forms the base for the investment to grow or compound over time.  In turn, a larger investment base  leads to faster growth over the life of the investment and a  bigger payout when the funds are eventually withdrawn.

 In comparison, if this person had made their investment using after-tax dollars, two things would be different.  First, they would have only $7,920 to invest because the original $11,000 would have been reduced by tax withholdings (assuming the person was in the 28% tax bracket).  Because of this smaller investment base, the growth that would occur would be smaller when compared to the pre-tax base.   Second, the $7,920 could be further reduced when it came time to pay income taxes.  This would arise because the person could have to include any returns earned (like savings account interest) as part of their income base on their tax return.  The result?  The tax liability calculated could be higher, triggering increased tax payments.

 Yet despite all the good things about pre-tax investments, there is one primary downside.  No matter how hard an individual may try, they can not entirely escape paying taxes.  Although pre-tax dollars aren’t taxed when the funds go into the plan, they are taxed when they come out.  Furthermore, not even death can alleviate the tax obligation on these saving plans.  Whatever remains in the account at the time of your death will be taxed prior to distribution to your heirs.  Yet in many people’s eyes, the benefits of investing with pre-tax dollars tends to outweigh all the above.