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401(k) Tax Advantages

Warren Buffett said it best: “Someone is sitting in the shade today because someone planted a tree a long time ago”. To reach the recommended $1 million ($2 million if you’re a millennial!) nest egg goal for most retirees, starting to contribute early to a retirement account is key. The U.S. government provides tax incentives to both companies and employees to encourage them to set up and save with 401(k)s, and people are taking advantage of it: according to the latest data from the U.S. Department of Labor, over 77% of private retirement plans in the U.S. are 401(k) plans. Saving for retirement is very obviously a good idea, but given the additional tax benefits and breaks of a 401(k) in particular, it's an absolute must to be informed about how much this can help you financially, both now and in the future.

The immediate benefit: Lower your tax bill

Every time that you contribute to your 401(k) using pre-tax dollars from your paycheck, your taxable income decreases. This is possible because you’re deferring taxation until retirement, when you’re more likely to be in a lower tax bracket than during your working years.

Let’s assume that you made $60,000 in total taxable income in 2015 and that income will remain the same for the next five years. As a single filer with no deductions, you owed $10,800 in income taxes to the IRS for the first year. By contributing to a 401(k), here is how much less you could haved owe in income tax:

Total Contribution to 401(k) Total Income Tax Difference from your
regular tax payment ($10,800)
$1,000 $10,550 -$250
$2,000 $10,300 -$500
$3,000 $10,050 -$750
$5,000 $9,550 -$1,250
$10,000 $8,300 -$2,500
$18,000 $6,300 -$4,500

In 2015, individuals under 50 were able to contribute up to $18,000 to your 401(k) and those 50 and over could contribute up to $24,000. As you can see, just by socking away $3,000 into your 401(k) in 2015, you would have been able to pocket $750 that year than by not contributing anything to your 401(k). Assuming the same scenario for five years, you would pay a total of $3,750 less in taxes for that period.

In 2018, you'll be able to contribute and save even more.

The more you contribute to your 401(k), the less you pay on income taxes, which can be especially beneficial in higher income tax brackets.

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Start early or adjust accordingly

Let’s imagine that your retirement goal is $1 million and that your 401(k) includes an index fund with an average annual return of 7% compounded annually. Your target retirement age is 65.

If you start saving at age: You'll need to contribute (monthly): Which is this much annually:
20 $280 $3,360
30 $580 $6,960
40 $1,260 $15,120
50 $3,190 $38,280*

*However, IRS caps 401(k) contributions at $24,000, so please start saving early!

If you're relatively young: As you can see, the later you start, the higher the absolute amount of money you will have to set aside. Start contributing in small amounts now, and you'll still have more saved eventually than if you don't contribute anything at all -- this is thanks to compound interest, which can be very beneficial to you if you have time on your side.

If you're nearing retirement: Using a 401(k) is still beneficial for those starting late to save for retirement. First, a 401(k) has a higher contribution limit ($18,000 and $6,000 in catchup contributions) than an IRA ($5,500 and $1,000 in catchup contributions). Second, when using a 401(k) instead of a traditional IRA to save for retirement you may delay required minimum distributions (RMDs) past age 70 1/2 by continuing to work. Under this scenario, you would continue to make contributions, your 401(k) would continue to grow tax-free, and your first RMD would be on April 1st of the year after you retire. Not all 401(k) plans allow this tactic, so talk with your plan administrator in advance.

The long-term advantage: Pay less in taxes during retirement

The years go by and now you’re 65. Let’s assume that you reached your goal of a $1 million nest egg. You don’t want to change your lifestyle at all and decide to live on $60,000 every year.

Assuming that you withdraw the entire $60,000 from your 401(k), here is the breakdown of your applicable income taxes:

Taxable Income Taxes Due
$0 - $9,275 10% of taxable income
$9,276 - $37,650 $927.50 + 15% of amount over $9,275
$37,651 - $60,000 $5,183.75 + 25% of amount over $37,650

Instead of being taxed at a flat 25%, each portion of your $60,000 is taxed at different tax brackets. Here is a summary of the IRS tax schedules for 2016.

But this is assuming that you have no additional sources of income, which is often not the case. For example, the average monthly social security benefits payable in January 2016 was $1,341 or $16,092 per year. Let’s assume that you only get $1,000 a month or $12,000 per year. This means that you would only need to withdraw $48,000, paying only income taxes on those $48,000. The more additional sources of revenue that you have during retirement, the less that you have to withdraw from your 401(k) and the less that you have to pay on income taxes.

Depending on your sources of income during retirement, you could make adjustments to stay in a lower tax bracket. For example, to stay in the 15% tax bracket, you could fund a total of $10,350 ($48,000 minus the $37,650 upper limit of the 15% tax bracket) from a savings account or annuity. Or you could adjust your lifestyle to reduce your necessary expenses.

Resist taking early distributions or loans from your 401(k)

Remember: You have to follow the rules to get the tax breaks!

The IRS is willing to give you a tax break on your 401(k), but you have to follow three important rules:

  1. Don’t take early distributions (before age 59 1/2): Not only will you pay at a lower tax bracket than in retirement but also you’ll pay an extra 10% penalty. Certain states may charge additional income taxes and penalties. This is to encourage long-term saving.
  2. Keep contributions at or below the maximum limit: The IRS allows you to withdraw excess deferrals no later than April 15th of the following. Any excess deferrals not withdrawn by the deadline are subject to double taxation; that is, they're taxed both in the year contributed to and in the year distributed from the plan. Also, excess deferrals may be subject to early distributions penalties when done before age 59 1/2. Contact your plan administrator to find out up to how much you can contribute to your plan (often, a percentage out of compensation). This is to
  3. Pay back all 401(k) loans in full: Any unpaid loan balances from 401(k) become taxable income and can be subject to early distribution penalties. Generally, 401(k) plans that allow loans permit planholders to pay loans within five years or 60 days after termination of employment.

In sum, a 401(k) provides substantial tax advantages, such as a higher contribution limit than some retirement accounts and tax deferral until retirement. However, you need to play along by the rules set by the IRS.

A note for corporations (employers, small business owners, and HR departments)

As we've mentioned above, the U.S. government wants to encourage people to save for retirement and provides strong financial incentives for doing so through a 401(k). Because they know that 401(k)s are company-administered, they also provide corporate tax credits and benefits as well!

You can read about this in more detail here, but here are the main points:

  • Corporate tax credit: $1,500 over three years for new 401(k) plans.
  • Tax deductible company match: Because 401(k) matches are deductible from a company's income, this is a more cost-effective way to reward employees than a bonus or a raise while lowering your tax basis. It's a double-sided tax benefit, since neither the company nor the employee have to pay taxes on the match, whereas with a raise or a bonus, both the company and the employer are losing out on the full raise or bonus amount due to taxes.