11/18/2023
There are many qualified retirement accounts that people can use to help them save for retirement. “Qualified Accounts” are those that receive some form of special tax treatment to incentivize us to save. This article will discuss the main points of a 401k plan.
Section 401 covers qualified pension, profit-sharing, and stock bonus plans. Section 401k of the Internal Revenue Code provides the foundation for cash or deferred arrangements and is about 10 pages long. While the Code is complex, the gist of Section 401k is that it permits employees to defer compensation by redirecting a portion of the earned income into a 401k plan on a pre-tax basis, thus lowering your taxable income.
To give a simplistic example, let’s say you earn $50,000 per year. That would place you in the 22% tax bracket, ignoring all other exemptions and deductions, for 2023, for a single earner. Putting 10% into your 401k, or $5,000, would effectively save you $1100 in taxes for the year.
While this is a nice benefit, I have been told, “I would rather have the extra $3750”. But, there is more. If your company matches your 401k contribution, there is an additional benefit. While company plans vary, most plans match the first 3% of deferred salary. That would account for an extra $1500 in matching, putting your total contribution for the year at $6500. Your taxable income is still reduced by the $1100.
This looks like a fairly good way to save money. But wait, it gets even better. Your earnings, as you dollar cost average, grow tax-deferred, meaning that your dividends and capital gains are not taxed in the year that they occur. In fact, they don’t really get taxed at all.
Over the long term, this is a great way to accumulate assets. The downside is that when you take the money at retirement, your account is taxed at the ordinary (earned) income rate. In effect, it becomes your retirement salary. Between the match and the deferral, you should come out ahead in the long run.
