In this article, we will look at the advantages of making salary deferral 401k contributions to employer sponsored retirement programs.
1) Reduces Your Current Taxable Income
Contributions towards an employer sponsored 401k retirement plan are made in before-tax dollars. This means your current taxable income for the year is reduced by the total amount of contribution you have made. For example, you might be single and earn $50,000 this fiscal year. However, if you make a $4000 contribution towards a 401k retirement plan this year, your current taxable income for the year will be reduced to $50,000 – $4000 = $46,000. Say hypothetically, you are in the 25% tax bracket. Here are the results:
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Before Making 401k Contributions
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$50,000 x 25% = $12,500 Tax Owing |
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After Making 401k Contribution of $4000
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$46,000 x 25% = $11,500 Tax Owing |
After making 401k contributions of $4000, you have lowered your current tax owing from $12,500 to $11,500.
Note: This is only a hypothetical example. Individual results are based on current taxable income, amount of 401k contributions and what tax bracket you fall into.
Note also that you will eventually be taxed on this $4000 you contribute towards a 401k plan. However, if you do this at the age of 65 (when you are not working and are in a lower tax bracket), you will pay a much lower tax at the age of 65, as opposed to now. Make sense?
2) No Taxes Owing on Earnings
Another advantage of contributing towards a qualified 401k retirement plan is the fact that any earnings you make on your contributions are also tax-deferred up until you retire or withdraw your money. For example, consider this hypothetical example:
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Annual 401k Contributions
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$4000 |
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# of Years of 401k Contributions
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10 Years |
| Interest Rate (Compounded Annually) | 8% |
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Future Value of 401k Investment
|
62,581.95 |
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Original Principal
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$4000 / year x 10 Years = $40,000 |
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Earnings
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$62,581.95 – $40,000 = $22,581.95
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Until the time you make 401k withdrawals or turn 65 (upon retirement), you will NOT be taxed on this earnings amount of $22,581.95. Say you are in a tax bracket of 25% at the moment earning $50,000 a year. However when you retire, you will be in a tax bracket of only 10%. This means when you withdraw this earnings amount of $22,581.95 at the age of 65, you will be taxed only 10%, as opposed to getting taxed at your current tax bracket of 25%. Make sense?
3) Employer Match 401k Contributions
Most employers will match your 401k contributions upto a certain percentage amount. You should atleast make salary deferral 401k contributions upto the percentage amount of 401k contributions your employer is willing to pay for you. Consider this hypothetical example:
James works for Coco Corporation and has an annual gross salary of $40,000. His employer said he will make employer matched contributions of $0.55 per every dollar that James contributes, upto 5% of his salary. Here’s what’s going on:
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John’s Annual Wage
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$40,000 |
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5% of John’s Annual Wage
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$2000 |
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John Contributes $3000 this year to 401k Plan
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$3000 |
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Employer Matched 401k Contribution =
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$3000 x 0.55 = $1650 |
Therefore, what is the total sum of 401k contributions that John and his employer are making together?
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Total 401k Contributions
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$3000 + $1650 = $4650 |
What will the nest egg of John be after 10 years? Using a table similar to the one we used above, here are the results:
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Annual 401k Contributions
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$4650 |
|
# of Years of 401k Contributions
|
10 Years |
| Interest Rate (Compounded Annually) | 8% |
|
Future Value of 401k Investment
|
$72,751.52 |
|
Original Principal
|
$4650 / year x 10 Years = $46,500 |
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Earnings
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$72,751.52 – $46,500 = $26,251.52
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John contributing solely to the 401k plan would have resulted in a nest egg of $22,581.95 in 10 years. However, John and his employer matched contributions combined would result in a nest egg of $26,251.52. The difference is a huge:
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Difference =
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$26,251.52 – $22,581.95 = $3,669.57
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