Personal Finance Concepts – P5DB January 9, 2008 To: Sal From: James Morgan Subject: 401(k) Plan Dear Sal, thank you for asking me such a complicated question like investing in your 401(k) plan. So, let’s try to find out how much you will save in taxes by contributing to your 401(k) plan. As far as I understood, you can invest into 401(k) plan up to 10% of your income, with your current income of US$50,000 per year. As you are making US$50,000 per year, you fall into the 25% federal income tax bracket. Obviously, investing in 401(k) plan is a great thing, and I am pleased to know that you think about your retirement. From this point of view, 401(k) plan allows you to feel financial security when you will retire, and also allows you accumulating wealth. As far as you, probably, know, a 401(k) plan is a defined contribution employee benefits plan, and it allows you tax-deferred retirement savings.
What does it mean? To put it differently, the word defined contribution means that you contribute your money to the plan, usually through a payroll deduction, and the money in this plan, 401(k), is tax deterred money. It means that you do not pay taxes on the money when you contribute them into your 401(k) plan, but you will pay the taxes on them when you will withdraw and use the money during your retirement. Although you might tell that you will still be obliged to pay your taxes, the truth is that usually the amount of taxes to be paid when you retire, will be less than now and you will save a lot. Now, to make the explanation easier, lets calculate how much you will save in taxes by contributing to your 401(k) plan, taking into consideration several investment choices: 2%, 4%, 6%, 8%, and 10%.After we complete the calculation, we will try to find out whether there are other suggestions to minimize your taxes. So, you are making $50,000 a year and fall into the 25% federal income tax bracket. In case you contribute 10% of your salary, or $5,000, to a traditional 401(k), this 401(k) contribution reduces your taxable income to $45,000.
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As we can see from Table 1, in the 25% tax bracket, this will amount to $11,250. In case you contribute 8% of your salary, or $4,000, to a traditional 401(k), this 401(k) contribution reduces your taxable income to $46,000. In the 25% tax bracket, this will amount to $11,500. In case you contribute 6% of your salary, or $3,000, to a traditional 401(k), this 401(k) contribution reduces your taxable income to $47,000. In the 25% tax bracket, this will amount to $11,750. In case you contribute 4% of your salary, or $2,000, to a traditional 401(k), this 401(k) contribution reduces your taxable income to $48,000.
In the 25% tax bracket, this will amount to $12,000. Finally, in case you contribute 2% of your salary, or $1,000, to a traditional 401(k), this 401(k) contribution reduces your taxable income to $49,000. In the 25% tax bracket, this will amount to $12,250. Table 1 Traditional 401(k) Taxable Income – Savings This allows us making a conclusion that if you contribute 2% of your salary, investing in a 401(k), instead of receiving the money as taxable salary, cuts your annual income tax by $250.00. If you contribute 4% of your salary, investing in a 401(k), instead of receiving the money as taxable salary, cuts your annual income tax by $500.00. If you contribute 6% of your salary, investing in a 401(k), instead of receiving the money as taxable salary, cuts your annual income tax by $750.00.
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If you contribute 8% of your salary, investing in a 401(k), instead of receiving the money as taxable salary, cuts your annual income tax by $1,000.00. Finally, if you contribute 10% of your salary, investing in a 401(k), instead of receiving the money as taxable salary, cuts your annual income tax by $1,250.00, respectively. So, we can make a conclusion that investing 10% of your salary allows you to cut your annual income tax by $1,250.000 and will be obviously the best possible advice for you. However, you may consider other plans, such as Roth 401(k), or some others (The Basics: A tax-free retirement just got closer, 2007).
In case you are not in a low tax brackets and expect to be in a higher tax brackets after your retirement, you should obviously choose the Roth 401(k) (Retirement Q&A, 2007), because in the 401(k) plan your contributions come out before your taxes are calculated, and in the Roth 401(k) you will save on taxes when you withdraw the money. Another thing to take into account is that although there are no significant disadvantages to contributing to 401(k) plans, you should understand that the money you contribute to the 401(k) plan cannot be withdrawn until you reach the age 59.5 without a penalty. In case you would like to withdraw money before, you will have to pay taxes on the money withdrawn, and in addition, you will have to pay a 10% fine to IRS) (Understanding and Controlling Your Finances, 2007).
Yet, if you are now in high tax brackets and think expect to be in a lower tax brackets after your retirement, you should obviously choose the 401(k) plan. References Retirement Q&A. (2007).
Retrieved January 9, 2008, from http://www.quicken.com/cms/viewers/qanda/retiremen t/800 The Basics: A tax-free retirement just got closer. (2007).
Retrieved January 9, 2008, from http://moneycentral.msn.com/content/retirementandw ills/investyoursavings/p139175.asp Understanding and Controlling Your Finances. (2007).
Retrieved January 9, 2008, from http://www.bygpub.com/finance/finance6.htm.
