Many taxpayers assume that taxes apply to all earnings, income, and benefits equally, whether now or later. Of course, it’s more complex than that. Some benefits may not apply to taxes at all! Understanding the taxes of each component of your finances will allow you to make the right moves to build your wealth. We provide the details below so you can understand the difference between pre-tax and post-tax dollars.
When an employer provides benefits such as medical, vision, and dental insurance, the employee doesn’t need to worry about taxes on those payments. Similarly, they won’t need to worry about a tax obligation on other benefits, such as gym memberships, employee parking and commuting benefits, some childcare benefits, funds contributed to Health Savings Accounts, and more. Typically, the only thing other than regular income that you have to worry about being taxed includes additional income, such as tips and commission, as well as the below.
While benefits are typically not taxed, and income is taxed immediately, there are always earned dollars where tax is deferred. Contributions to your employer-provided 401k are not taxed except for payroll taxes such as social security and Medicare. You will pay taxes when you withdraw the funds many years later, but this money will have gone up in value. Additionally, your taxable income in retirement will likely be lower than it is now, therefore you won’t be paying as much in taxes later on.
Note this is the crucial difference between a traditional IRA and a Roth IRA. The IRS taxes your funds contributed to a Roth IRA now. Then, the growth of that IRA is then tax-free, even when you withdraw. For younger taxpayers, a Roth IRA may fit long-term goals better. Meanwhile, older taxpayers are better off with deferring their tax payments.
It’s essential to understand your flow of income and how and when it’s taxed, exactly. Always take advantage of putting away money pre-tax where you can. This will help you save money on taxes and give you the opportunity to grow wealth for the future. When you have the option between paying taxes now or deferring them, each can have its own advantages. Depending on your other circumstances, you can make the right determination for you.
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