Retire earlier with a 401(k)
Retire earlier
with a 401(k)
I am always extremely excited when I have a chance to talk about the 401(k) account. I believe the 401k is the best place to save for retirement because of its tax advantages over a regular savings account. Retire sooner AND get a helping hand from the IRS? Now that’s a win-win.
A 401(k) is a type of employer-sponsored retirement account that allows you to defer receiving pay today in exchange for receiving it later in retirement. Generally, you want to be paid sooner, not later. However, 401(k) accounts have a tax advantage that can make the deferral worthwhile.
Tax Benefit
Uncle Sam takes a piece of your income whenever it is earned. In addition, forty-three states and many localities have their own income tax on top.
The amount you contribute to your traditional 401(k) account avoids federal, state, and local income tax in the year they are made. Savings inside a traditional 401(k) account are also not subject to investment income tax, such as interest, dividends, and capital gains, in the year it is earned. Instead, income tax is due at the time of distribution. Therefore, savings inside a traditional 401(k) account are said to be tax-deferred.
Contributions to Roth 401(k) accounts are subject to federal, state, and local income tax, in the year it is earned. While there is no upfront tax benefit like in traditional 401(k) accounts, distributions from Roth 401(k) accounts are tax-free. Savings inside Roth 401(k) accounts are also not subject to investment income tax, such as interest, dividends, and capital gains. Therefore, Roth 401(k) accounts are said to grow tax-free.
Quantifying the benefit of 401(k) accounts
If you have to pay tax later anyway for traditional 401(k) accounts, does the tax-deferred growth really make a difference? The quick answer is - yes. To illustrate the tax advantage of both traditional and Roth 401(k) accounts over a regular savings account, let’s look at Jamie, Felix, and Ranie.
Jamie and Felix are planning to start saving for retirement this year. They each receive a $10,000 bonus and would like to put that towards retirement. Jamie chooses to save in a regular investment account, while Felix takes advantage of his employer’s 401(k) plan.
Jamie’s marginal tax rate is 24%. She pays $2,400 tax on the $10,000 bonus, and saves the remaining $7,600 in the investment account. Felix’s marginal tax rate is also 24%, but he does not owe tax because he contributes the entire amount to his 401(k) account.
Ranie is Felix’s coworker. She also receives a $10,000 bonus, and saves it towards retirement in a Roth 401(k). Since Roth contributions do not get a tax benefit up front, like Jamie, she will save $7,600 after paying 24%, or $2,400 in tax.
Jamie, Felix, and Ranie are rewarded with a $10,000 bonus every year, and they repeat their savings habit each year for the next 30 years.
Assuming their investments are identical and are able to grow their savings at 8% per year, Jamie and Ranie will have $860,952 in their accounts at the end of those 30 years. Felix’s account balance will be $1,132,832. Felix has more, but this is not a fair comparison because withdrawals are taxed differently from each of their accounts. For a fair comparison, we need to compare the after-tax balance of each account.
For illustrative purposes, let’s assume that the tax rate for Jamie, Felix, and Ranie remains consistent at 24%, and that their capital gains tax rate is 15%. Under these assumptions, Jamie’s retirement savings is worth roughly $766,009 after-tax, and Felix has $860,952 in his account after-tax. Ranie’s after-tax balance remains at $860,952 since distributions from Roth accounts are tax-free.
Despite the fact that Jamie, Felix, and Ranie saved the same amount over 30 years, and earned the same rate of return on their investment, Felix and Ranie have close to $100,000 more simply because they took advantage of their 401(k) plan. In other words, Felix and Ranie paid $100,000 in less tax!
There is no official tax for distributions from regular savings accounts. However, Jamie will owe capital gains tax when he converts his investment to cash. The growth of Jamie’s account, or the capital gains is, $860,952 - ($7,600 x 30 years) = $632,952. Jamie’s capital gains are taxed at 15%, and his capital gains tax comes to $94,942. Therefore, Jamie’s after-tax balance is $860,952 - $94,942 = $766,010.
Distributions from traditional 401(k) accounts are taxed as income. Since we are assuming the tax rate stays the same at 24%, the after-tax balance of Felix’s traditional 401(k) is $1,132,832 x (1-24%) = $860,952.
Savings inside a Roth account are tax-free, so her after-tax balance is the same as her Roth balance, $860,952.
An employee that expects their income tax rate to decrease in retirement will benefit by contributing to a traditional 401(k). For example, if the average tax rate decreased to 12% for Felix and Ranie, Felix would have a higher after-tax balance. One the flipside, if the average tax rate increased to 32% for Felix and Ranie, Ranie would have a higher after-tax balance. An employee that expects their income tax rate to increase in retirement will do better by contributing to a Roth 401(k).
When the tax rate remains, there is no difference between a traditional and Roth 401(k). Because of the great tax benefit with both types of 401(k) accounts, the IRS sets a limit each year on how much you can contribute. In 2020, employee contributions are limited to $19,500. Employees age 50 or older anytime in 2020 can contribute an additional $6,500, bringing their contribution limit to $26,000.
The 401(k) contribution limit applies across both traditional and Roth 401(k) accounts. An employee can contribute $19,500 ($26,000 for 50+) to a traditional 401(k) account, or $19,500 to a Roth 401(k) account, or any combination thereof, as long as the combination is not over the annual limit.
401(k) accounts are predominantly funded by your contributions, but some employers will give an incentive by matching a part of your contribution. Employer contributions do not count towards your annual contribution limit.
401(k) accounts are awesome because it helps you retire sooner by paying less tax, and to top it off, an employer match if available is like a cherry on top of an already delicious sundae.
I recommend that the general household save at least 20% for retirement. That means if your income is over $100,000, you should be maxing out your 401(k) annually and taking full advantage. If you’re not able to max it out right now, contribute enough to at least get the full employer match. Then, slowly increase your contribution, either annually, or quarterly, until you get to the max.
Everyone’s situation is different and my post is for educational purposes only. For recommendations that are appropriate for your individual situation, consult a financial advisor and tax accountant.
