When you use pretax dollars for your retirement investments, you reduce your tax bill for the current year. The government takes its cut of the money you invested when you withdraw it during your retirement years, or earlier if necessary. If you must withdraw the money early, you will usually have to pay a penalty, so only invest the money that you can afford to lose.
In an employer-sponsored plan, such as a 401k or a 403b, your employer takes a specified amount of money out of each paycheck and applies it to your retirement fund. The government then takes the taxes from your salary, minus the invested amount. In some cases, the employer will match the amount up to a certain percentage of your contributions. This significantly increases the money you invest. In most cases, you cannot withdraw money from the account without incurring a penalty until you reach age 59 1/2. But you can take a loan from the account and pay yourself back.
Individual Retirement Account
There are several types of IRAs, and two of the most popular ones are traditional and Roth IRAs. Only the traditional IRA uses pretax dollars. Open and fund this account on your own through a brokerage, then choose the types of investments you want. The limit on an IRA is $5,000 per year at the time of publication ($6,000 per year if you are 50 or older). There are certain situations where you can withdraw money penalty free before the age of retirement, including buying a home or paying higher education costs.
A Keogh plan is similar to the employer-sponsored options, but it's meant for self-employed individuals. The defined-contribution plan is similar to a 401k, with rules limiting penalty free withdrawals. There is a limit of 25 percent of your income or $49,000 each year. The defined-benefit plan is similar to a pension, where you invest a certain amount of money each month based on the amount of pension you want to receive during retirement.
Employer-sponsored plans invest the money before you see it, so it is not taxed by the government. When you contribute to an IRA or a Keogh plan, however, you may be using money that you've already paid taxes on. If this is the case, you can turn it into a pretax investment by including the invested amount as a deduction when filing your taxes.