What are pre-tax deferrals?

The definition of pre-tax deferrals highlights that these contributions are not subject to taxation at the time they are made. When an employee makes pre-tax deferrals into a retirement plan like a 401(k), the amount contributed reduces their taxable income for that year. Consequently, this can provide a tax advantage, allowing the employee to invest more toward retirement without immediately incurring a tax burden.

This concept is crucial for understanding how tax deferral works within retirement accounts. Taxes are typically assessed on these funds only when they are withdrawn, usually during retirement, when the individual may be in a lower tax bracket. This deferral mechanism is a key feature of 401(k) plans, incentivizing saving for retirement by allowing the contributions to grow tax-deferred over time, and offering individuals a potential advantage in planning their tax liabilities effectively.