Calculating 401(k) Benefits—the Power of Tax Deferral
Saving through a 401(k) plan is the best way to retire with real wealth because it is based on the power of compounding interest. All plan investment gains in the plan are not taxed until distributed. Plan assets can be carried from one employer to another and contributions can be made easily through payroll deductions.
Tax deferral literally means that you are putting off paying tax. The most common types of tax-deferred investments include those in IRAs or Qualified Retirement Plans (i.e., 401(k)s). Tax deferral means that all income, gains, and earnings, such as interest, dividends, rental income, royalties, or capital gains will accumulate tax-free until the investor or 401(k) plan participant withdraws the funds and takes possession of them.
As long as the funds remain in the retirement account, the funds will grow tax-free. This allows your retirement funds to grow at a much faster pace than if the funds were held personally, allowing you to build for your retirement more quickly. And when you withdraw your retirement funds in the form of a distribution after you retire, you will likely be in a lower tax bracket and be able to keep more of what you have accumulated. So, using a 401(k) plan as a retirement-savings vehicle, not only are you not paying taxes on the money you invested, you could be paying them at a lower rate when you finally do “take home” your money.
In other words, as long as the funds remain in the account, they grow without taxes eroding their value. This enables assets to accumulate at a faster rate, giving you an edge when saving for the long term.
Benefits of Tax-Deferral
By using a 401(k) plan to make investments, the 401(k) plan participant is able to defer taxes on any investment returns, thus, allowing the 401(k) plan participant to benefit in three ways.
The first benefit is tax-free growth: instead of paying tax on the returns of an investment, tax is paid only at a later date, leaving the investment to grow tax-free without interruption.
Next, is that retirement plan investments are usually made when the retirement-account holder is in his or her highest income-earning years and is thus subject to tax at a higher tax rate.
Lastly, is the ability to defer taxes on investments in the face of increased federal income-tax rates. With tax rates at a historic low (the highest income-tax bracket in 1986 was 50 percent and in 2020 is 37 percent), the likelihood of higher federal income-tax rates in the near future is significant. Especially, with the financial strain the baby-boomer generation is expected to have on the federal budget. Thus, the ability to defer tax on investments until the retirement-account owner is age 70 1/2 (and likelier to be in a lower tax bracket) makes 401(k) plans highly attractive tax beneficial investment vehicle.
Examples of Tax-Deferral
Example 1: Todd is thirty-five years old and makes a $10,000 annual contribution to an employer 401(k) plan until reaching the age of seventy. Assume Todd is in a 25 percent federal income-tax bracket. Further assume that Todd was able to generate a 6 percent average annual return on his investment. When Todd retires at the age of seventy, his 401(k) plan would be worth $1,150.237.
Example 2: Wendy is twenty-eight years old and makes a $7,000 annual contribution to her employer 401(k) plan until reaching the age of seventy. Assume Wendy is in a 25 percent federal income-tax bracket. Further assume that Wendy was able to generate a 5 percent average annual return on her investment. When Wendy retires at the age of seventy, her 401(k) plan would be worth $972,063.
Example 3: Jose is forty-four years old and makes a $15,000 annual contribution to his 401(k) plan until reaching the age of seventy. Assume Jose is in a 25 percent federal income-tax bracket. Further assume that Jose was able to generate a 6.5 percent average annual return on his investment. When Jose retires at the age of seventy, his 401(k) plan would be worth $848,852.
The numbers don’t lie, and the 401(k) plan can help the self-employed or small business owner build wealth fast, while at the same time also benefiting from tax deductions and a reduction of taxable income.