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There are three primary tax
advantages to participating in a 401(k) plan. They include:
Lower Income Taxes
Because your 401(k) contribution is deducted before taxes are taken out, you're be taxed
on a smaller sum of money, which makes your initial tax hit lower. An example: if you earn
$30,000 per year and are in the 28% tax bracket, your federal tax liability for the year
is $8,400. Under that same scenario, if you contribute 10% of your salary ($3,000) to a
401(k), your taxable income is decreased to $27,000. At a 28% tax rate, your federal
income tax liability will be $7,560 – that is $840 less than you'd pay if you didn't
contribute to a 401(k).
Increased Investing Power
Pre-tax investing increases your investing power by enabling you to save more. In the
example above, a 10% 401(k) contribution from a $30,000 salary is $3,000 per year. Ten
percent of your after-tax income, on the other hand, comes to less than $2,200.
Contributing before taxes enables you to save an extra $800 per month.
Tax-Deferred Compounding
Since you don't pay taxes on your 401(k) contributions or subsequent earnings until you
withdraw money at retirement, your savings accumulate faster. Say you contribute $2,000
per year to your 401(k) for 40 years, and your investment earns an annual return of 10%
each year. At the end of the 40 years, you will have contributed $80,000 to your 401(k),
but your account will be worth $973,684 – thanks greatly to the power of tax-deferred
compounding. |
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