The traditional 401(k) is a qualified employer sponsored investment account that employees make pre-tax contributions to each paycheck.
Pre-tax means the contribution is deducted before taxes infiltrate your gross amount of earnings. Paying pre-tax now, means you will then be paying these taxes on withdrawals in the future instead.
In 2017, each individual has a limit of$18,000 personal contributions and that money cannot be withdrawn penalty free until one of the following :
This is a bit simplified as there are exceptions to the rule or loans. Take a look at the IRS resource we quoted above: Resource
How do people use this account in retirement?
By reducing your tax bill now during your working years (meaning you’re in a higher tax bracket), then you will be able to pay less taxes on withdrawal during retirement.
Those in retirement tend to be in a lower tax bracket since they no longer work 8+ hours for income each day.
With taxes not being taken out and investments growing tax free throughout the long holding period, this gives those high contributors the magic of compound interest.
We’ll dive a bit more into the numbers below!
By utilizing your pre-tax, post-tax (like a Roth IRA), social security, and outside investment accounts you can fine tune your strategy to take advantage of paying less taxes in your retirement!
Read this: Why Setting Financial Goals Matters
For the three reasons below, let’s use the following paycheck scenario:
For our examples, we’ll forgo any other taxes/deductions in the mix.
As we defined above, traditional 401(k)’s are a pre-tax investment. A Roth 401(k) is offered at some employers, but we are focusing on the traditional in this post. Here’s a quick example displaying the pre-tax concept:
With $1,000 gross on your paycheck and contributions at 8%, then we can calculate the reduction in taxes quite easily.
You have successfully saved the 25% tax on the $80 you contributed pre-tax into your account!
Say this with me: “More Money Invested!!!”
Bring it in….bring it in…say it again “More Money Invested!!”
That’s right! Let’s go back to our $1,000 gross paycheck example.
Instead of deducting that pre-tax pay, you decide that instead you want to instead invest 8% (or $80) of your gross into your non retirement brokerage account.
The results look minuscule here due to the $1,000 paycheck.
That still equates to $40 a month and even more so for larger paycheck (a 50K salary would be a ~2K gross bi-weekly paycheck).
Have you heard companies will contribute free money to your 401(k)? No? Well it is true!! Most companies will anyway.
Employer’s want to help you make better financial decisions and to utilize the retirement accounts they provide. To do this, they offer a match!
For example, they may match you percento y percento up to 4% contributions. This means that if you contribute 4% of your salary to your 401(k), then they will as well. FREE MONEY!
Many employers have a vesting time range that requires you to work for a certain amount of years before they are free to keep the money a company invested. If you leave before, then they take the money back.
It’s good to ask about this when you enroll in your company 401(k) program.
Save on taxes + more money invested to compound + Free Money = Triple Threat Results!
Three events adding up to more investment money growing with the super power of compound interest, leading you to a better retirement!
With the definition being set and three reasons to contribute, we can take a look at a few numbers using the Bank Rate Contribution Calculator. I want to show you the difference in contributing 0%, 8%, or 36% (to max your 401(k) on a $49,400 salary as a 22 year old.
The screenshots below show the paycheck changes and account balances at age 65; reiterating that the earlier you start investing the better, and the amount of taxes you can save each month by contributing more to your pre-tax account. or each calculation we used a 7% return, which could be incorrect for the future of the stock market – even though it has been the historic return rate.
Both of these scenarios are using the age range of 22 to 65. Maxing out your 401(k) early can have drastic effects on the rate of compound interest you have in your life time.
Changing your contribution from 8% to 36%:
Contributing 36% of your paycheck on this salary is a HUGE ask.
We understand and want to just use the same baseline for showing the benefits you get from maxing out your 401(k) starting at a young age.
Bank rate doesn’t ask for the investments you will make in your account to get a return of 7%.
401(k) investment options are negotiated between your employer and the fund provider, giving you limited options to invest in. The key is find diversification through index funds of different types and low fees.
Further, the money grows tax free here, so tax-free municipal bonds wouldn’t be the best choice. See the investment post linked above for more details!
Utilizing your 401(k) for pre-tax contributions helps you save money on taxes and grow your investments at a larger rate.
Not paying taxes now can lead to more taxes later if they were to increase, yet to us it still seems like the best approach for those on the FIRE (Financial Independence Retire Early) journey.
We are among those who will be paying off our debts, buying more experiences and less things (like Zack and Jen believe in as well), and readying our greenback ($$) troops for retirement.
With this mentality and knowledge, there are strategies one can use to best utilize and pay lower taxes when you are ready to recruit more dollars into your bank accounts during retirement.
Let us begin with a huge thank you to Zack and Jen. We appreciate the opportunity to post on an inspiring site for the Personal Finance Community. I’ve met plenty of people in my life, some who know about finances and some who don’t. People who cared very deeply about their future, and people who cared deeply about their favorite sports team. People who love their job or people in their life. I have a deep admiration for those who are willing to sacrifice in pursuit of their dreams.
This couple (Zack + Jen) accelerated their code red debt free mission by living in a camper – a sacrifice many of us wouldn’t be able to make ourselves. Both of us Duke’s really were inspired by this, and hope we can fire some of that same inspiration from you today!
The Master Duke’s of Dollars are the dynamic duo from The Duke of Dollars Kingdom. We’re two guys who have consistently relied on each other to vet ideas and fervently discussed topics ranging from individual stock picking to deciding on if one should pay off their mortgage. Our abnormal count of personal finance discussions turned into the blog and the mission we have created for it. The younger of us Chris, the one writing this guest post, just began the Great War of Debt and recently obtained a positive net worth. Jack is farther down the road towards FIRE (Financially Independent, Retired Early), meaning we each have different perspectives to share with the community. We have one main mission: helping others achieve in building their financial kingdom, or in other words, providing the world with a road-map to follow that leads to a strong personal monetary policy.
Need more inspiration? Check out this video about compound interest from another fellow blogger over at ReisUp.
Zack is one of the co-founders of FreeUp and is in charge of setting the strategy for the blog and managing the day-to-day operations. When he isn't plotting new ways to create awesome blog content, he likes to geek out about global affairs, ride motorcycles and can probably be found hiking somewhere during his days off.