Pre-tax income vs. post-tax income is one area that is so commonly overlooked by so many people until they start taking a closer look at their personal finances.
It’s so important to understand the difference between your gross pay and actual income so that you can plan your finances more accurately. Yet, many of us don’t really know or understand what that difference is until we see it on our income tax documents the following year.
Your annual salary doesn’t paint the whole picture of your finances. That being said, let’s look at the difference between pre-tax and after-tax pay and how it impacts your wallet.
What is Pre-tax income?
Pre-tax income is your total income before you pay income taxes but after your deductions and is also known as gross income. For instance, your pre-tax deductions would include your retirement investment accounts such as a Roth IRA, 401(k), 403 (b), and health savings accounts. Let’s say your salary is $40,000, and you invest 10%, which equals $4,000; your pre-tax income is now $36,000, which is your taxable income.
So, rather than paying taxes on $40,000, you will only pay taxes on $36,000. Your net pay is lower because you reduce your taxable income by depositing money into your pre-tax investments.
What is Income after tax?
Your pay after tax deductions is known as your income after tax or your net income. Your income will determine what tax bracket you are in and what percentage of taxes you will pay. There are seven federal tax brackets, and the percentages range from 10%-37%. These tax brackets make up the progressive tax system in the U.S. This simply means that you are taxed at a higher rate based on your income in each tax bracket.
Your pay after tax is considerably less than your pre-tax income. You need to be sure you set up your budget based on your income after tax and not your pre-tax income because your net income is the actual amount of money you will be bringing home after taxes and deductions from your paycheck.
Pre-tax income vs. income after tax: what’s the difference?
When people talk about income and salary and 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 and other deductions have been taken out of your salary.
Deductions withheld from your paycheck may include:
- Federal: Based on your gross income and the information on your W-4
- State and/or local (if applicable)
- FICA: the U.S. Federal payroll tax for Social Security and Medicare
- Insurance: health, dental, group life.
- Savings: 401k, pension, FSA
What’s left is your take-home pay (aka your net pay) and how much you really earn.
Though you may get paid post-tax, many people still think about their annual salary in terms of their pre-tax amounts. Your annual pay after-tax deductions can be considerably less, which causes some people to assume they make more than they really do. This in turn can greatly impact their overall financial planning. As a result, they may spend more than they can actually afford.
Example of pre-tax income vs. income after tax
Meet Lisa. Lisa makes $50,000 a year pre-tax but 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.
|Lisa’s Income: Pre-tax vs. Post-tax|
|Actual income after taxes||$37,500|
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 them later. She books the vacations and upgrades her car and also her 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 can be a slippery slope.
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 financial goals.
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 traditional 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 income goes into these accounts each pay period, and then you're taxed on the rest. When you invest in pre-tax accounts, your taxable income is reduced, and thus, you'll pay fewer taxes each year.
Post-tax accounts are basic savings accounts you might put money into every pay period after taxes. Post-tax accounts examples include ROTH IRAs, brokerage accounts, CDs, mutual funds, index funds, and education accounts, like 529s or ESAs.
While post-tax accounts do not lower your tax liability, they still have huge benefits as well. This is because they give you the opportunity to save and invest even more. So don't let this be your only consideration when deciding how and when to save money.
Figuring out your pay after-tax
Fortunately, you don’t need to do too much work to figure out how much you’re making after taxes. Take the guesswork out of what you are actually earning with the help of a paycheck calculator. The National Endowment for Financial Education's calculator and this payroll adjustments and take-home pay calculator” are also beneficial tools to help you get started. Your paystubs will also have a breakdown of the deductions taken from your check. And you can also ask HR about them.
Don't plan out your finances on a $50,000 salary when you really only make $37,500 after taxes. Don't get caught up in massive loans that banks will qualify you for based on your pre-tax income. Do your due diligence and understand what your pay after tax is and what you can really afford. It's entirely up to you to properly assess your pre-tax income against what you can feasibly afford.
By learning the difference between pre-tax income and post-tax income, you can plan your finances accordingly and prevent financial mishaps. You can also learn how to improve your financial wellness with our FREE courses and worksheets!