Why Save Through a 401(k) Plan?
The biggest advantage of saving through a 401(k) plan is that contributions are elective and can be can create a tax deduction. In addition, all income and gains from plan assets grow without tax. This is known as tax-deferral or tax-free growth in the case of a Roth 401(k) plan contribution.
Tax Deferral
Tax deferral literally means that you are putting off paying tax. It 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 solo 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 accumulated. So, with using a solo 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.
Summary of Benefits
By using a 401(k) plan to save for retirement, the 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. The second benefit of tax deferral is that the 401(k) plan investments are usually made when the plan participant is in his or her highest income earning years and is thus subject to tax at a higher tax rate. The third benefit is the ability to defer taxes on investments in the face of increased federal income tax rates.
With tax rates at a historical low (the highest income tax bracket in 1986 was 50% and in 2020 is 37%), the likelihood of higher federal income tax rates in the near future are 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 plan participant reaches the age of 701/2 and likely in a low income tax bracket makes a solo 401(k) plan a highly attractive investment vehicle.
