Putting aside pre-tax dollars into a 401k benefits you now, but it also benefits you in the future when you have to use the money. Though some of the tax advantages of a traditional 401k go away if you withdraw the money before you turn 59 1/2, you can make use of most of the advantages during retirement.
Lower Taxable Income
Your employer will take out your 401k contributions before it withholds your tax payments. For example, if your gross pay is usually $2,000 and you decide to put 10 percent into the 401k, you'll only have to pay taxes on $1,800 of your earnings. The higher your income and the higher percentage you can set aside for your 401k, the greater the impact this will have on your tax bill.
Lower Income Tax Later
You only have to pay taxes on the money that you withdraw from your 401k account. If you downsize your life in the retirement years -- purchasing a smaller home, reducing transportation costs and living on a budget, or example -- you can reduce the amount of taxes you'll have to pay. For example, if you were earning $150,000 at the end of your career, but can get by on $45,000 during retirement, you are in a lower tax bracket and paying less tax than you would have if you hadn't put the money in a 401k while you were working.
In addition to the tax-deferred contributions that you make to the 401k, the money that the account earns is also not taxable until you withdraw it. This is in sharp contrast to other types of investments like savings accounts, which require you to pay yearly taxes on the interest you earn. SunTrust points out that over 30 years, this could be a difference of over $50,000.
Heirs Deferring Taxes
You can pass on the money in a 401k to your heirs. When someone inherits a 401k plan, he has the option of taking it in a lump sum, or spreading the distribution out over his expected lifetime. Smaller distributions over time can spread the tax burden out for your loved ones.
- Comstock Images/Comstock/Getty Images