If you haven’t noticed already, I hate spending money. I don’t know why people buy stuff they don’t need, only to throw it out a few months later because the quality is junk. Wow, why does it feel like I’m starting to sound like my grandpa? Don’t get me started on how many miles I used to walk to school, uphill both ways, in constant snowstorms. But what really upsets me is paying taxes! Not paying taxes is not an option (I’ve checked). So the next best option is minimizing what you need to legally pay. A 401k benefits you by deferring taxes. Note that there’s no way to avoid taxes (only corporations are allowed to do that). Deferring taxes is great because even though you’re deferring the payment, you benefit from the power of compounding. Below, I have some examples to answer the question, “How much money will a 401(k) save me?”
The concept is fairly simple, but it can have huge implications on your finances. In a normal investment account, you buy stocks using after-tax income and you are taxed again when you sell the investment. So if you make $1,000 and you’re in the 25% tax bracket, you’ll have $750 to invest after paying the government. If you sell your investment in less than a year, you pay the marginal tax rate on whatever the gain is over the initial $750. Below are the marginal tax rates for 2016.
2016 IRS Tax Table
|Tax Rate||Single||Married Filing Jointly||Married Filing Separately||Head of Household|
If you hold the investment for longer than a year, you’ll pay the long-term capital gains tax rate, which could be up to 20%, when you sell. This is much lower than the top marginal tax rate of almost 40%, which is good.
With a 401(k), you invest with pre-tax dollars. So using the example above, you can invest $1,000, not $750. And if you sell that investment at any point, even if it’s less than a year, you don’t pay taxes. So your money gets to grow tax-free! You are only taxed when you take the money out at retirement, at ordinary income tax rates.
Taxes are Like a Bad Boss
It seems like a 401(k) wouldn’t save much money because you’re still paying taxes, but just deferring the timing. But delaying taxes is really helpful because your investments grow throughout all those years, tax free.
It’s like when you have a boss hassling you every 10 minutes for something (I know this happens to you too because I refuse to believe I’m the only person that has suffered through this). Every time you start back up and try to be productive, your boss sets you back. You are so much more productive when you can work uninterrupted.
The same thing happens to your investments. It’s trying to grow and every time you sell something, the government comes in and takes a little (sometimes a lot), so it’s not growing as fast as it could. The 401(k) basically blocks out the bad boss so you can get work done! Sadly, there’s nothing out there that can block your real boss.
How Much Money Will a 401(k) Save Me?
Below, I have an example to highlight how much money you could save. I have two savers, each starting out at 25, saving $1,000/year. Saver #1 is using a normal investment account, so she only saves $750 because she’s being taxed on the rest. Saver #2 is saving $1,000 because she’s using a 401(k), so she gets to invest pre-tax dollars. Both savers are generating a 6% annual return. However, Saver #1 only sees a 5.1% after-tax return, assuming a 15% tax rate on gains, because she’s selling some assets each year and paying taxes.
In the first year alone, Saver #2 has 33% more money although the difference is only $250. After 5 years, the difference is 36%, or almost $2,000. After 20 years, Saver #2 has almost 50% more money, or $12,000. And after 40 years, Saver #2 has 68% more, or $67,000!
|Age||Saver #1||Saver #2||Difference|
Some of the more astute readers (you’re all astute since you’re on this site) will say, “Hey, but Saver #2 hasn’t paid any taxes yet!” You’re right, so the above isn’t a fair comparison. If we use a 25% tax rate on the ending balance, Saver #2 would still have $124,000, or 26% more.
Some of the more more astute readers will know that I can’t write good. But they’ll also say, “I’m a long-term investor. What if I invested my after-tax dollars like Saver #1, but I don’t sell anything until I retire?” If you invested $750 a year from 25 to 65 with a 6% annual return, you’d have a little under $110,000, after paying a 15% capital gains tax at the end. So the 401(k) is still the best option.
How Much Should i Save for Retirement?
That’s a great question. The answer is as much as you can. A 401(k) is beneficial because not only does it save on taxes, but you get the tax break right now! If you put in $1,000 a year, you would only miss $750 of it now because you saved $250 on taxes. Of course, there’s no sense living like a miser to have a comfortable retirement. However, it does make sense to take a careful look at what you actually need now, so that you can have a comfortable retirement in the future. If you haven’t already, see if a refi is right for you to find additional money to put in a 401(k).
For 2017, the maximum contribution limit is $18,000, with an additional $6,000 of catch-up contributions for those 50 and older. I’ve contributed the max for many years now, but that’s because I’m lucky to be in the financial position to do so. If you can’t put in the maximum, your goal should be to put in what you can now and increase it as your financial situation improves.