What Is a Pretax Contribution?

Laws in many countries enable entities and individuals to make pretax contributions to certain types of savings accounts. In countries that lack a national healthcare program, an individual may be able to make a pretax contribution to a health care savings account. Many pretax contributions involve retirement accounts and pension plans.

Taxpayers in most countries are required to pay regional or national income tax on their earnings. An individual who makes a pretax contribution reduces his or her income tax liability by that sum. In some countries, individuals can deposit their entire annual earnings into tax-deferred accounts in which case these individuals have no income tax liability. Typically, there are laws limiting the amount of money that individuals can deposit into pretax accounts and in many instances, high earners are unable to make tax-deductible contributions.

In some countries, employers are able to make pretax contributions to pension plans on behalf of employees, and employees are typically able to make their own elective contributions to these accounts. Plan participants do not have to pay income tax on their own contributions or the contributions made by employers until withdrawals are made from the account. Generally, rules exist that prevent pension plan participants from making withdrawals prior to the nationally recognized retirement age. Premature withdrawals are typically subject not just to standard income tax, but also to potentially hefty tax penalties. Similar withdrawal restrictions normally apply to retirement accounts that individuals create themselves without the involvement of their employers.

Aside from retirement plans, in many countries a taxpayer may have the option to make a pretax contribution to a college savings account. Typically, people can create such accounts for their own benefit but they also have the option to fund these accounts on behalf of their beneficiaries. As with pension plans, these accounts normally grow on a tax-deferred basis. Either the account beneficiary or the individual who founded the account must pay a tax penalty if account proceeds are used for anything other than college expenses.

Laws enabling an individual to make a pretax contribution to certain kinds of accounts are designed to encourage taxpayers to save money for essential long-term expenses. Many governments provide taxpayers with the opportunity to make tax-deductible contributions so that public funds do not have to be used to fund pension plans or college tuition. Nevertheless, in some areas people with limited income are able to take advantage of tax deductions and still qualify for financial aid and state pensions.