The 401k gets a lot of love from investors because they can be a vehicle to amass wealth rapidly. When I first heard the word tax advantage account or pre-tax investing, I didn't know what anyone was talking about. At first, it sounded a lot like regular investing to me. After doing some reading, I began to understand that when you invest your money before taxes are taken out, it can grow a lot faster. Below we run through what tax advantaged means and why a 401k helps you invest more money.
For every dollar you personally contribute to a 401k, it lowers your earned income. Lowering your earned income means you can often save on taxes. In some cases, it can even move you to a lower tax bracket. As of 2019, the tax brackets look like this:
|Rate||For Unmarried Individuals, Taxable Income Over||For Married Individuals Filing Joint Returns, Taxable Income Over||For Heads of Households, Taxable Income Over|
To run through an example, if your salary was $90,000, the last $7,800 of your income would be taxed at 32%. The way taxes work is you are taxed on your income up to the tax bracket, then anything over that is taxed at the higher rate. It's a bit confusing, but here's an example of our hypothetical $90,000 salary:
If our person contributes $10,000 to a 401k, her total earned income is reduced to $80,000 which is underneath the $84,200. Because they contributed to a 401k, they moved down an entire tax bracket! While this might not seem like much, it can add up over time. In our example, our person would pay around $12,980 in taxes without doing any 401k investing. With the contributions to their 401k, they will only pay $10,780. This is a savings of $2,200, plus the added benefit of having $10,000 invested and growing in the market!
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While our person is able to invest $10,000 a year into their 401k, that doesn't necessarily mean that the $10,000 is coming directly out of their paycheck. To invest $10,000 after taxes you would need to make roughly $12,500. The calculation looks like this:
$13,500 - ($13,500 x 25%) = $10,125 after taxes
When it's pre-tax you don't even have to worry about taxes. It's pulled directly out of your account. To see what your actual out of pocket cost to you was you use this formula:
amount invested pre-tax - taxes saved
Our investment was $10,000 and if you read the example above we saved $2,200 in taxes. This gives us an out of pocket cost of only $7,800. You effectively got to invest $2,200 right away that you otherwise would not have been able to! This is why it is best to try and do as much pre-tax investing as you can.
By investing pre-tax you can invest larger amounts up front and get the benefits of compounding interest earlier. As we saw in the previous example, if had to invest only post-tax you would not be able to invest as much. That is why the 401k is so crucial and also why they limit contributions per year. The tax advantage is huge and it allows you to sock away more money than you might otherwise be able to.
Let's stick with the example where our person invests $10,000 a year into their 401k. If they remain consistent and work 30 years, this is what their 401k looks like.
Starting amount: $0 | Additional yearly: $10,000 | Growth Rate: 7.0%
Value after 30 years: $1,010,730.37
After 30 years, they have over $1 million dollars! This is a basic example and doesn't account for salary increases, increased contributions, etc. Their total contribution of $300,000 more than tripled over time. The beauty is that of that $300,000 only $234,000 was out of pocket.
Putting as much money as you can to work in the market is a strategy used to build wealth. Taking advantage of the tax advantaged accounts can set you up for a comfy retirement. Even if you are only able to contribute a little, you will see you money add up and your tax bill will go down.
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