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Financial Learning Center


The Nuts and Bolts of a 401(k) plan

Should You Participate in a 401(k) Plan?

There are a number of advantages to participating in a 401(k) plan. Your contributions are pre-tax, which gives you more money to invest. Your earnings are not taxed until withdrawal. (Earnings in the Roth 401(k) are not taxed at all.) You have the option of rolling your 401(k) into other tax-deferred employment plans if you change employers. You have access to some of the money in an emergency. Your employer may match your contribution—in effect, giving you a bonus. And the plan will let you choose from a variety of investments.

You will pay taxes on your 401(k) plan contribution and earnings when you begin to take the money out of the 401(k) plan (generally at retirement). But the remarkable advantage is that even after you have paid taxes on your 401(k) account, you still have accumulated much more money than you could with a taxable savings account.

Let's take a look at an example to show what it really costs you to make a 401(k) pretax contribution. Assume you get paid a gross monthly salary of $3,500 and your tax rate is 25%. You contribute 10% of your gross pay to the 401(k) plan. Does it really cost you $350? No, after the tax 'benefit', it only costs you $262. You'll pay taxes eventually, but when you make a 401(k) contribution, the money going into the plan is not taxed currently.

 

No 401(k) Contribution

401(k) Contribution

Gross monthly pay

$3,500

$3,500

401(k) contribution

$0

$350

Taxable pay

$3,500

$3,150

Taxes paid

$875

$787

Net monthly pay

$2,625

$2,363

If you contribute $350 each month to a 401(k) plan, your net take home pay is $262 less than if you hadn't contributed anything. In other words, you saved $350 for retirement, but your take home pay was only reduced by $262. You saved taxes of $88, which you put into your retirement fund.

In addition to these tax savings, low to middle income taxpayers may be eligible for a tax credit for contributions made to a 401(k) plan. To qualify for the tax credit, adjusted gross income must be less than $64,000 ($63,000 in 2018) if married filing a joint return, $48,000 in 2019 ($47,250 in 2018) for head of household, or $32,000 ($31,250 in 2018) for all other filing (i.e. single, married filing separately, and qualifying widow(er)). The maximum credit rate is 50%, and the maximum contribution amount that may be used for calculating the credit is $2,000 (same as 2018).

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