Understand 401k contribution

Question

I decided to add 5% in the 401k from this month and thought it will reduce my tax income but I don't see the much difference in Tax. Can someone help me understand that. My FITW Tax reduced from $459.21 to $401.92. That is only $57.29 tax saving per-bi-weekly check and $114.58 monthly tax saving. I'm contributing $260.42 that is $520.84 monthly and saving only $114.58 monthly. Its like losing $520 for me that I could have use for something. Can someone highlight the benefit of this?

Answer 1

While you are losing a lot of monthly take home income, you are gaining a tax advantage, increasing your income, and net worth. Every two weeks (two months per year you will get three paychecks in the month) $260.42 goes into a savings account that is not meant to be used until you are aged 59.5. That is okay, you will need this money in order to retire.

However by doing such you get an extra 57.92 in your paycheck. So even though you cannot spend the money now, you are much better off. Basically you are getting $60 every two weeks, for saving $260.

If your company has a match, you maybe even better off than you imagine. While it will not show up on your pay check it will show up in your 401K account.

Money saved in a 401K is that which cannot be counted on for a long time. That is okay, your future self will thank you and you will wished you have saved more earlier.

Answer 2

Using the numbers provided in the question, contributing $260.42 to 401(k) reduces the federal income tax withheld by $57.29.

Thus the marginal tax rate is $57.29 / $260.42 = 22%.

Furthermore, $260.42 bi-weekly represents 5% of the annual income, which means the annual income is 26 * $260.42 / 5% = $135418.40.

22% tax bracket is the expected one for this amount of annual income - in other words, payroll calculation is correct.

Can someone highlight the benefit of this?

The main benefit is saving for retirement. In addition, this reduced tax liability.

Answer 3

I do think it's worth pointing out that while you are certainly paying less taxes today by diverting money from your current paycheck into your 401k, the longterm implications are a bit more nuanced. The taxes on your 401k contributions are deferred, not exempted. You'll still pay taxes on that income when you eventually withdraw it from your account to spend it in retirement. In short, my primary conclusion about 401k retirement saving vs. Roth IRA savings is to make your best guess as to whether you expect your tax rate to be lower in retirement than it is today, and if so then a 401k is great. If you think you'll live like a king in retirement and be at a higher bracket, then you should max out your Roth IRA contributions each year (pay taxes now, and all investment returns are tax-free).

Investopedia has a good summary article here:

• https://www.investopedia.com/ask/answers/100314/whats-difference-between-401k-and-roth-ira.asp

You’ll pay taxes after you reach retirement age and begin to make withdrawals from the plan. These distributions, as they are known, are subject to income taxes at your then-current tax rate.2 If you think your income will be higher when you retire, you may want to plan ahead, as all income from your distributions will be taxed.

Answer 4

Here’s a question. What do you do with money you pocket? Do you spend it? Or do you save and invest it?

If you spend it, then it’s gone - unless you spend it on a few very particular things that gain value (a mortgage/house is one of them, but not nearly as much as you think.

There are a lot of people who just “spend it all” - whatever they get, they spend it. Boom gone. Psychological motives are very important to look into, but I don’t want to go too far off topic - suffice it to say it’s like they “push money away”: unspent money is bad somehow and can’t be suffered.

Such people tend to spend a lot of money and not have much to show for it at the end.

But there is tremendous merit in savings. What 401Ks do for you is “bribe” you into saving. “Oh, we can’t get Americans to save? Here, here’s a financial motivation to do that. And the 401K is structured enough to seem distant, so people who destroy all money that is near them will leave it alone. Mostly.

The real cure for that, honestly, is financial education - so people understand the sheer power of saving. Unfortunately this often involves over-riding the lessons about money that were taught by your family, which are often very, very bad lessons, but you want to adhere to them because you think it signifies love of your family. I don’t universally endorse “Rich dad, poor dad” but the author talks about reconciling that.

Anyway, the “skip the lesson, tell me what to do” version is that savings is very good, and 401Ks are a particularly good savings method for an especially good cause.

As far as taxes, yeah, in the short term you get immediate and significant tax savings. It’s true you will eventually pay tax on that money, but it will be less tax (in theory), and, there are other ways to beat it.

• For instance, if you ever have a “gap year” where you have very little income, you can convert portions of your 401K into a Roth 401K. In a Roth, the taxes are pre-paid and aren’t taxed again. You need to pay tax on the money you convert, but, you have very little income in a gap year, so the taxes are at a very low rate.

• If you’re good at savings, you can even plan to have a gap year where you take a sabbatical from work and do volunteerism, explore the country or world, etc.