In this article, we will
look at the advantages of making salary deferral 401k
contributions to employer sponsored retirement programs.
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:
Before
Making 401k Contributions |
$50,000
x 25% = $12,500 Tax
Owing |
After
Making 401k Contribution of $4000 |
$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?
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:
Annual
401k Contributions |
$4000 |
#
of Years of 401k Contributions |
10 Years |
| Interest
Rate (Compounded Annually) |
8% |
Future
Value of 401k Investment |
62,581.95 |
Original
Principal |
$4000
/ year x 10 Years = $40,000 |
Earnings |
$62,581.95
- $40,000 = $22,581.95 |
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?
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:
John's
Annual Wage |
$40,000 |
5%
of John's Annual Wage |
$2000 |
John
Contributes $3000 this year to 401k Plan |
$3000 |
Employer
Matched 401k Contribution = |
$3000
x 0.55 = $1650 |
Therefore, what is the total
sum of 401k contributions that John and his employer are
making together?
Total
401k Contributions |
$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:
Annual
401k Contributions |
$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 |
Earnings |
$72,751.52
- $46,500 = $26,251.52 |
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:
Difference
= |
$26,251.52
- $22,581.95 = $3,669.57 |
