"Pre-tax vs. post-tax income (take-home pay) is one area that is so commonly overlooked by so many people when they start taking a closer look at their personal finances."
When people talk about income and salary and they tell you how much money they make, the numbers they mention are usually pre-tax numbers. That means they're speaking of their income before any taxes get taken out. The thing is, when you get paid, your salary gets paid post-tax. This means you get paid after taxes have been deducted from your income. This is your take-home pay AKA how much you really earn!
How much do you really earn?
Though you may get paid post-tax, many people still think about their overall salary in terms of their pre-tax amounts. This causes some people to assume they make more than they really do which can have a major impact on their overall financial planning. And in turn, may cause them to spend more than they can really afford.
Confusing? Here's an example:
Meet Lisa. Lisa makes $50,000 a year pre-tax, but her biweekly post-tax salary after 25% taxes (assuming 25% is her tax bracket plus other deductions) is $1,562.50. This means post-tax, Lisa really only makes $37,500 a year. But because she's never really sat down to calculate her overall post-tax salary, Lisa still tells herself that she makes $50,000 a year.
From a mindset perspective, $50,000 is a lot more than $37,500. So Lisa buys things that cost way more than she can really afford because in her mind she will somehow be able to pay for it later. She books the vacations and upgrades her car and her also closet. After all, she makes $50,000 a year. She might not even realize the mistake she's making in the way she's determining her income.
This is the way many people plan out their incomes - on their pre-tax earnings. The most dangerous part? Creditors will qualify you for loans and mortgages based on your pre-tax income without taking your post-tax income into consideration—now that's scary!
Does this make sense yet?
Do you ever feel like you make all this money a year but you never seem to have enough money based on what you think you earn? Take a step back and think about your yearly income from a post-tax perspective. Then, create your budget accordingly. This simple exercise can make all the difference as you create your monthly budget and set your yearly financial goals.
Don't plan for $50,000 when you really only make $37,500 after considering taxes. Don't get caught up in massive loans that banks will qualify you for based on your pretax income. Do you own due diligence and understand what you can really afford. It's entirely up to you to properly assess your pre-tax income against what you can feasibly afford.
Investing in pre-tax vs post-tax accounts
It's not just your salary that's subject to differences in pre-tax vs post-tax status. There are investment accounts that distinguish between pre-tax and post-tax as well. The main difference? What your tax bill looks like at the end of each year. Pre-tax investment accounts, like Roth IRAs, 401(k)s and some pension accounts, are accounts you invest in on a pre-tax basis. That means a pre-determined amount of your money goes into these accounts each pay period, and then you're taxed on the rest.
Post-tax accounts are more familiar; they're the basic savings accounts you might put money into every pay period. Other post-tax accounts are brokerage accounts, CDs, mutual funds, index funds and education accounts, like 529s or ESAs.
When you invest in pre-tax accounts, your taxable income will be reduced, and thus, you'll pay fewer taxes each year. And while this isn't the case when you save in post-tax accounts, those still have huge benefits as well, so don't let this be your only consideration when deciding how and when to save money.
Do you understand the difference between pre-tax vs post-tax income and investment options better now? It's definitely an eye opener once you've realized the difference!