How Standard 401(k) Plans Save People Money on Taxes
With a standard 401(k) plan, the idea is to not pay tax on the amount you contribute, and defer taxation on it until you retire and your income goes down. This often places one in a situation where the contributed amount gets taxed at a lower rate then it would have been had it not been contributed to the tax shelter vehicle, such as a standard 401(k) or a traditional IRA.
People often speak of being in a certain tax bracket, moving to a higher tax bracket or to a lower tax bracket. Income as a whole isn’t taxed in one bracket or another, it’s that portions of income are taxed in certain brackets. So there’s an amount that doesn’t get taxed at all, another bracket that gets taxed a certain amount, a bracket above that that gets taxed a greater amount, and so on.
If one defers the taxation on a portion of their income, we need to look at what tax would have been paid on it, and this sometimes will involve a portion of it being taxed in one bracket and a portion taxed in a higher bracket.
So we can see cases where one’s income may have gone down somewhat but the tax paid is still taxed at the same rate. However, as long as one does not get taxed at a higher rate later, there will be benefits accrued by deferring the tax, provided one’s investments generate a positive return over time, which always should be the case unless one has made some very bad investments.
So there are two main benefits to tax deferral, the tax savings itself, and the return on investment of the deferred tax. To use a simple example, if one has deferred $100,000 in a 401(k), and would have paid $25,000 in income tax if not deferred, this $25,000 sits in the investment account, and earns or at least should earn a tidy sum over the years.
So even if you end up owing the $25,000 in retirement, you’ve made money on this. If you owe less, and only end up paying $15,000, you’ve saved an additional $10,000. You also benefit from the principal amount owed being devalued by inflation, and the IRS is actually losing money every year by letting you defer the tax, because a given amount becomes worth less each year in real dollars.
With a 401(k), if you get the additional benefit of your employer matching your contributions to a certain percentage, that’s a real bonus. If it’s a 50% match, in our example, the employer would have added $50,000 to your total, and you now have $150,000. You will be responsible for paying tax on this extra $50,000 when cashed in, but even after tax, this can be a very nice boost to your retirement savings in itself.
Roth 401(k) Plans
Like IRAs, 401(k) plans also have what is called a Roth option, were contributors do not defer tax on the principal, they instead get the benefit of the distribution of their contributed amounts being tax free.
In our example, just looking at our own contributions, with a Roth we will contribute $75,000 instead of the $100,000, with the standard 401(k), since we had to pay the $25,000 tax on this up front.
Let’s assume we double our initial investment within the plan during our saving years. So the standard 401(k) is later worth $200,000, and all of this is subject to income tax when withdrawn. After taxes, assuming the same rate, we’ll end up with $150,000.
With the Roth 401(k), we double our amount to $150,000 over the years, but no tax is payable on any of this. So in this simple example we end up in the same place. So whether we should be going with a standard or Roth 401(k), or a standard or Roth IRA for that matter, all really comes down to whether we expect our tax rate to go up or down in retirement.
Few people expect it to go up, so standard 401(k) plans remain the most popular. When you no longer receive your employment income, as is the case when you retire, unless you have done extremely well for yourself, it’s usually not the case that this replacement income is going to exceed your employment income.
So you can’t really go too far wrong with the standard 401(k) in most cases, however the Roth option won’t really hurt you, as the only thing you are foregoing is the potential tax savings from having all or a portion of it taxed at a lower rate than you would have paid up front.
Contributing and Withdrawing from a 401(k)
Like IRAs, contribution limits are capped with 401(k) plans, although they are capped at higher amounts. In 2017, individuals under 50 can contribute up to 18,000 on their own, with those 50 and older being allowed an additional $6000, to a total maximum of $24,000. This extra allowance is to allow people closer to retirement to catch up if needed, which is why it’s called the catch up amount.
There is also a total maximum amount that an individual and their employer can contribute jointly to one’s 401(k), which is $54,000, with an extra $6000 allowed for persons 50 and older. The total amount cannot exceed the employee’s earnings, not including 401(k) matching amounts.
This gives you a sense of just how high the employer’s contribution can be in some cases, which can exceed 100% of the employee’s contributions.
The higher the percentage that the employer contributes, the more tempting that these plans should be to employees, and the more they should dedicate putting in as much as they can into it, to get as much extra money as they can from their employers.
When it comes to withdrawing 401(k) funds, while IRAs can be withdrawn prior to age 59 ½ by paying a 10% penalty, 401(k) savings can only be withdrawn prior to age 59 ½ under exceptional circumstances. Once one reaches that age though, then withdraws can occur.
Given the desire a lot of people have for instant gratification, seeking to spend more of their money now and save less, there is nothing that comes close to looking to correct this tendency and get people pointed more on the road to doing the right thing for their retirement than a 401(k).
This is because there is actually a financial penalty involved in not contributing, due to missing out on the employer match of their contributions, and this is often enough to tip the scales between one’s long term welfare and one’s short term gratification, where often people do need this help.
In any case, 401(k) plans do provide even more benefits than this, the potential to pay tax back at a lower rate, the ability to pay tax on income in amounts that have been discounted by inflation, the opportunity to invest this deferred tax and generate a return on it over time, and with a Roth IRA, the ability to earn investment income tax free. So this is very often a wise choice indeed.