Tax Savings, Part 1 Of 4: Why You NEED To Contribute To Your 401(k).

This is a guest post from My Financial Objectives. Catch the rest of his four part series at his site!

People are hesitant to start contributing to their 401(k) for many reasons; the current state of the economy, a feeling of youth, the notion that retirement is a long way off, other bills to pay, etc. Whatever the excuse, the benefits a 401(k) offer should make one’s decision to contribute a much greater priority.

This is the first of four posts outlining the four biggest reasons as to why it is so important to contribute to your 401(k). The four main reasons are:

  • Tax Advantages
  • Employer Contributions
  • Compounding Interest
  • Others

The tax savings associated with a 401(k) may be more influential than many people realize, probably because many people may not realize that you save on money on taxes not once, not twice, but three times (a ladyyy”¦). When you make the decision to contribute to your 401(k) you will receive a tax break during the initial contribution, while your money is growing, and when you finally take you money out (sort of).

The FIRST tax savings you receive with a 401(k) is known as pretax savings. People often refer to this as “paying yourself first” and in this case even BEFORE you pay the government (and THAT’S a good feeling). Every dollar that you contribute to your 401(k) is an extra dollar that is not included in your income for the purposes of calculating you federal income tax (the upfront tax advantage).

Example: If you’re salary is $40,000 in 2010 and contribute $2,000 to your 401(k), you’re taxed as if you had earned only $38,000 for the year. Assuming you are in the 25% tax bracket means that you just saved $500, the 25% of that $2000 you would otherwise have had to pay in taxes.

Assuming we are in the 25% tax bracket, it would actually cost us $2,500 (an extra $500) to save $2,000 outside of the 401(k). Why? Because in order to save $2,000 AFTER TAXES, means that $2,000 has ALREADY been taxed according to the 25% tax bracket, resulting in $500 straight to Uncle Sam. If you put that money into a 401(k), the entire $2000 will go into savings. What makes more sense to you, save $2000 and get a tax cut with your 401(k), or save $2,000 after taxes and pay an extra $500 to the government? I think the choice is clear, a BLT is an excellent choice for lunch and maximizing your 401(k) contributing is a much more effective way to save for retirement.

The SECOND way that you receive a tax advantage with your 401(k) is that it will continue to grow tax deferred. This means that you will not pay any taxes on the interest, dividends, or capital gains within your 401(k). This is an incredibly powerful incentive which actually leads into my second post about compounding interest which I will be posting soon. The benefits of compounding interest and a tax deferred growth can turn an ordinary investment into retirement savings that you can live off of for 30 years.

Example: Assume you save $2000 in a savings account, not your 401(k). Now assume you earn 7.5% interest per year on this savings account (good year huh!?), but because of taxes, you have to pay 15% per year on that growth! Suddenly that 7.5% looks more like 6.38%, resulting in a total gain of only $127.6 instead of $150. I realize that is a small difference, but imagine the difference if we were talking about $200,000 instead of $2,000. In that case it’s a difference of $2,240 in one year!

The THIRD tax advantage associated with your 401(k) is that when you retire and start to withdraw money from your 401(k) that income will likely be subject to a lower tax rate (probably). The caveat to this is if you actually are in a higher tax bracket when you retire than you are during your working years. If that happens to you, I want to know what you did to accumulate that much wealth. In addition, this notion assumes that we will still be using the same graduated income tax system, which, considering we have had it for the past 100 years or so, I’d say is a pretty good chance. If you were to retire today, those lower tax rates would be 10% and 15%. Essentially you just changed your tax rate from 25% to less than 15% on some of that money! I’ll take that!!

I hope this has been helpful, and will convince any of you who have not started to contribute to your 401(k) to do so. Also keep in mind that if you though that this was convincing, there are still THREE MORE sections of additional benefits associated with a 401(k). I have intentionally kept this short, simple and to the point. One thing that turns me off when I am reading about a difficult subject, or trying to show a friend/coworker convincing information, is long drawn out incredibly in-depth articles. Hopefully this information will help many people realize how valuable a 401(k) really is, Now if you have not done so already, please, start your 401(k) contribution!

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Comments (10)

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  1. Also, I’ve always viewed it as the only REAL way to save money, because you never even see it.

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  9. […] in a simple easy to understand format.  This post was orginally posted at mytwodollars as a guest post.  This is the first of four posts outlining the four biggest reasons as to why it is so important […]