Investing in a 401k can result in both short-term and long-term tax savings. Most 401ks are designed to hold pre-tax earnings, but some employers also sponsor plans that contain after-tax earnings, and these plans can provide you with even greater tax savings than the traditional plans. The tax benefits of a 401k are even greater if your employer offers company matching contributions, because the Internal Revenue Service affords the same tax treatment to contributions made by your employer.
The elective deferrals that you deposit into your 401k plan are deducted from your wages before income taxes are assessed. If you fall into the 25-percent tax bracket, then you would have 75 cents after tax if you did not invest in the plan. If you invest, then your whole dollar goes into the plan. You do have to pay tax when you make withdrawals, but people typically fall into lower tax brackets when they have retired. If you fall into the 15-percent tax bracket when you retire, then you end up with 85 cents after tax when you make your withdrawal. Additionally, investing in the plan reduces your taxable income for the current year, and this could cause you to fall into a lower tax bracket for the current tax year.
Money inside a 401k plan grows tax-deferred, which means you do not have to pay income tax on dividends and interest generated by your account holdings. Furthermore, you do not pay capital gains tax if you sell securities within the account for profit, as long as you keep the sale proceeds within the 401k. If you get a 10-percent return on your dollar, you get to keep and reinvest that return within the plan. You would have to pay either capital gains tax or regular income tax on such a gain on a taxable investment. Investors refer to the process of continually reinvesting your proceeds as compounding, and this tax-deferred compounding continues until you withdraw funds from the account.
With a Roth 401k you make your deposit on an after-tax basis, which means that if you pay 25-percent income tax, you only get to invest 75 cents in the account. If you leave the money in the Roth 401k for five years and wait until you are 59 1/2 to make a withdrawal, then you pay no taxes on your earnings. If you held your 75 cents in the account and it doubled in value, then you would have a tax-free return of $1.50. If you invested another 75 cents in a taxable account for the same time frame and had the same growth, you would have to pay capital gains tax on your $1.50. Capital gains tax amounts to 15 percent, so you would lose 22.5 cents to taxes.
The tax advantages of a 401k are greatest if you keep the money in the account for an extended period because of the effects of compounding. However, if you make non-qualified withdrawals before you are 59 1/2, then you pay income tax and a 10-percent tax penalty on your earnings and on withdrawals of pre-tax contributions. Therefore, consider your short-term and long-term plans before you decide how much to invest in your 401k to ensure you do not actually increase your overall tax bill by investing in the plan.
- Internal Revenue Service; 401(k) Resource Guide - Plan Participants - General Distribution Rules; May 2011
- Internal Revenue Service; 401(k) Resource Guide - Plan Participants - Limitation on Elective Deferrals; May 2011
- CNN Money: What Tax Benefits do 401(k)s Offer?
- Smart Money; Understanding the Roth 401(k); Aleksandra Todorova; January 2011