Realizing Your 401K Tax Savings | Home Finance Help

Calculating the 401K tax savings makes investing for your retirement a lot easier. The IRS has given you a great opportunity that you cannot pass up.

What is the 401K Tax Advantage?

To illustrate here is an example of someone trying to decide between saving outside of a retirement plan or investing into a 401K. They have $300 of pre-tax income to invest bi-weekly.

• 25-year old
• Estimated retirement at 67
• Income of $60,000 (25% federal tax bracket, plus state income tax)
• Company offers a Traditional 401K
• Ability to contribute $300 bi-weekly until retirement
• Employer offers a 50% match on the first 6% of pay

Assumptions

8% average return
4% withdraw rate at retirement per year

Why such a big difference?

First, employer matching. Think of it as giving up a free raise by not investing in your 401K.

Second, you never pay taxes even from capital gains and dividends.

Outside of retirement accounts, holding a mutual fund forever doesn?t mean there is no tax. There are many ways you can be taxed even if you?re not selling. That turns into money that could have been invested and compounded for many years.

Paycheck Difference

A lot of the excuses for not investing is not wanting to see a decrease in salary. However, just because you contributed $300 per paycheck doesn?t mean you see a decrease of $300. In the example above there would only be a $204 decrease, $96 of each paycheck would go directly to taxes.

If you decided to invest in a taxable account, the $300 before tax ends up being $204. What would you rather do, invest $436 because of your employer match into a 401K or $206 into a taxable investments?

In the above example, investing in the 401K would earn the very smart investor $6,065 extra a month from age 67-90.

Other Tax Advantages

It?s worth mentioning that there are more tax advantages to investing in your 401K. Every time you rebalance your portfolio in a taxable account, you?re taxed if funds are sold for a profit. Over a period of 40 years that is a lot of taxes.

As you get older, the more you start moving your investments into more conservative assets, which requires selling off mutual funds with years and years of compounded interest. That sale is also taxed. Rebalancing and moving to more conservative assets in a 401K have no tax penalties at all.

The tax protection you get inside of your 401K and other retirement accounts can simply not be matched. If you?re investing for retirement there is no other way to invest.

Source: http://www.thehumblemumble.com/realizing-your-401k-tax-savings/

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