Certified Plan Sponsor Professional (CPSP) Practice Exam

How are pre-tax contributions taxed upon withdrawal from the plan?

1. They are taxed at a flat rate.

2. They are subject to federal, state, and local taxes when withdrawn.

3. They are completely tax-exempt.

4. They are taxed only at the federal level.

The correct answer is: They are subject to federal, state, and local taxes when withdrawn.

Pre-tax contributions are subject to taxation upon withdrawal in a manner consistent with how income is generally taxed, which includes federal, state, and local taxes. When individuals contribute to a tax-deferred retirement plan such as a 401(k) or traditional IRA, they defer taxes on that income until withdrawal. At the time of withdrawal, the entire amount—including both the pre-tax contributions and any earnings—is considered taxable income. This means that not only federal income tax applies, but also any applicable state and local taxes, depending on the individual's jurisdiction. The situation described in the other options is not accurate because a flat rate tax does not apply to all taxpayers. Tax exemption during withdrawal is uncommon for pre-tax contributions, as the essence of these contributions is that taxes are deferred, not eliminated. Additionally, tax liability is not limited only to the federal level; it extends to state and sometimes local taxes as well, emphasizing the comprehensive nature of taxation on pre-tax contributions upon their withdrawal.