Getting started on your retirement savings when you're in your 20s or earlier means your money has longer to grow before you retire. Using a tax-deferred plan, like a 401(k) through your employer, lets you make those contributions with pretax dollars. Though boosting your 401(k) contribution might save you money up front, it could also cost you money in the long run.
Contributions With Pretax Dollars
When you contribute to a 401(k) plan, your employer takes out money from your paycheck and puts it into your 401(k) plan. That money isn't counted as taxable income when you file your income tax return, which saves you money. For example, say your salary for the year is $22,000 but you contribute $1,000 to your 401(k) plan. Your W-2, the form that reports your taxable income at the end of the year, will only show $21,000 of wages that are subject to income taxes.
Savings Depend on Tax Bracket
The amount that you save on your taxes depends on what tax bracket you fall into. Your tax bracket refers to the tax rate applied to your last dollar of income. The higher your tax bracket, the greater your savings with a 401(k) contribution. For example, if you're in the 10 percent tax bracket, a $1,000 401(k) contribution will only save you $100 on your taxes. If you fall in the 25 percent tax bracket, on the other hand, you'll save $250 with that same $1,000 contribution.
Taxes Are Only Postponed
Contributing to a 401(k) plan only defers paying taxes on income; it doesn't avoid it completely. When you withdraw the money that you put in years down the road, you must include that money as part of your taxable income in the year you take the withdrawal. For example, if you put in $1,000 today and it grows to $2,500 by the time you reach retirement, you pay taxes on the $2,500 when you take it out. So, if you're expecting to be in a higher tax bracket at retirement, you might save money on taxes now but end up costing yourself later on.
Roth 401(k) Alternative
If you're expecting to be in a higher tax bracket later in life, consider contributing to a Roth 401(k) instead of a traditional 401(k) plan, if your employer offers one. With a Roth 401(k), you don't get any deduction for making your contribution. However, when you take qualified withdrawals in retirement, the contributions and your earnings come out tax-free. For example, if you put $1,000 in a Roth 401(k) when you're in the 10 percent tax bracket, you miss out on $100 of tax savings. But, if that $1,000 grows to $2,500 at retirement, you won't pay any taxes on the entire $2,500.
If you want the best of both worlds, you can divide your contribution between the two types of retirement accounts. In 2018, the maximum contribution to an individual retirement account is $18,500 for those under 50 and $24,000 for anyone who turns 50 before the end of the year. If you are 51 and want to contribute the maximum $24,000, you could divide the $24,000 between a traditional and a Roth 401k. For example, let's say you put $12,000 in a traditional 401k and $12,000 in a Roth 401k. You'll enjoy the benefit of decreased taxable income and pay fewer taxes when it's time to retire and you want access to your funds. As your investment increases, you can adjust how much goes into each account depending on your financial standing and which tax benefit you prefer.
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