21 Mar What Are Pre-Tax vs. After-Tax & How Do They Apply to Me?
Often when talking about finances, budgeting, and investing, people throw around the phrases “pre-tax” and “after-tax” as conventional forms of speech. But what does it actually mean, and how does that apply to you? Today, we will break down these phrases into layman’s terms so that you know what the heck they are talking about.
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What Does “Pre-Tax” Mean?
Pre-tax is defined as “(of income or profits) considered or calculated before the deduction of taxes.” Huh? Put simply, pre-tax income is the amount of money that you earn before any deductions are made; this is before you pay city, state, or federal taxes.
For example, if you work a salary job where you get paid $70,000 a year, your pre-tax income is $70,000. If you work an hourly job where you get paid $2,000 per paycheck, you will have a pre-tax income of $2,000. Lastly, if you work a non-standard job with multiple sources of income, then you would add up all the money you made that month; let’s pretend it is $2,500 for that month, your pre-tax income is $2,500. Got it? Good!
What Does “After-Tax” Mean?
Let’s take a quick trip down memory lane. Do you remember when you got your first pay stub? You were so excited to look at the big number listed at the top of the pay stub. You had earned that money! Then, like most people, you saw little bits of your payment being taken away, until you reached the bottom of your pay stub where your actual takeaway amount was…and it may have been a bit disheartening. That right there is your after-tax income. Don’t be sad; it is not as bad as it seems.
After-tax is defined as “relating to income that remains after the deduction of taxes due.” This is the amount that is left after Uncle Sam (the government) takes their share of your money; AFTER they have deducted city, state, and federal taxes. Essentially, it is the actual amount that ends up in your bank account.
How Does it Apply to You?
We know what you are thinking, “So how does this apply to me?” Great question! The main thing to keep in mind about pre-tax and after-tax is budgeting. Let’s say that you are working that $70,000 a year salary job. That $70,000 is pre-tax, so if you go out and spend it all…you won’t have enough to pay your taxes at the end of the year. That is why you need to budget according to your after-tax income amount.
Therefore, if you are earning $70,000 a year pre-tax, you math it out to find that your after-tax income is $55,000 (this number is an example, it’s not a real calculation). So, you budget your monthly expenses not to exceed that $55,000. Makes sense, right? The other aspect that you need to keep in mind is planning for your retirement.
Pre-Tax and After-Tax Accounts for Retirement
When it comes to planning for your retirement account, some options are either pre-tax or after-tax based. For example, pre-tax accounts that you can invest in include traditional IRAs, 401(k)s and 403(b)s, pensions, and more. What this means is that you have not yet been taxed on this money when you invest it. This is great in that you don’t yet have to pay taxes on the money you just earned, and it can lower your tax bracket. Plus, since you haven’t paid taxes on it yet, your interest can add up faster. However, the downside is that you will have to pay taxes on all of it (what you deposited and what you earned) when you take it back out during retirement.
The other option is to invest in an after-tax style account, such as a ROTH IRA. This style of account (also called a tax-deferred account) has you invest with money that you already paid taxes on. While the downside is that you have to pay taxes now, the plus side is that you won’t have to pay them later. This means that you will have to pay fewer taxes when you retire, and you would be in a lower income bracket then instead of now.
To make this really simple: with pre-tax accounts, you pay taxes later, and with after-tax accounts, you pay taxes now. Essentially, you just have to decide if you want to pay taxes now or later. For more information on this topic, read our article about Traditional IRAs Vs. ROTH IRAs.
Calculating Pre-Tax and After-Tax
Calculating your pre-tax income is easy; it is simply the sum of all the money that you earned that month. Just add it up and don’t deduct anything.
Calculating your after-tax income is a bit more involved. If you work a regular W-2 job where you get a pay stub at the end of every month, you don’t need to do much because they do it for you! It will likely list the total amount of deductions taken right there on the pay stub. If not, simply take your amount earned, subtract your net pay, and you will have the total amount of deductions. For example:
$4,000 earned (big number at the top) – $3,500 net pay (what ends up in your bank account) = $500 deductions.
If you are not a standard worker, like a freelancer, it is going to be a bit different. It depends on where you are from because every city and state has different tax rates. We suggest using this calculator from Smart Asset if you want to do a quick calculation of your estimated monthly after-tax income. For more detailed information, you can speak with a tax accountant.
Like we said above, understanding your pre-tax and after-tax income is essential for budgeting and retirement accounts. To learn more read our article on How to Set a Budget or check out our explanation of 401(k)s and IRA Retirement Accounts.