Fun With The 401k; Short-term Deferral Of Income

Fun With The 401k; Short-term Deferral Of Income

Everyone knows the 401K is a valuable savings tool. By deferring paying income tax on your savings you give your money the opportunity to grow tax-free until retirement. With some luck you'll be in a lower tax bracket upon retirement, sweetening your balance even more.

Everyone knows the 401K is a valuable savings tool. By deferring paying income tax on your savings you give your money the opportunity to grow tax-free until retirement. With some luck you'll be in a lower tax bracket upon retirement, sweetening your balance even more.

Of course you're not supposed to withdraw this money until you retire, and the IRS even tries to enforce this by assessing a 10% penalty on any early withdrawals.

What if you could delay paying income tax on part of your income? I'm not an accountant, but it seems to me that the 401K allows exactly that. Of course it lets you delay paying tax until retirement, but even if you'll need the money before retirement there may still be a benefit to this, particularly for high wage earners. Check articles about personal finance 

Let's say you're a high wage earner paying federal taxes at the 35% rate and state taxes at 9%. You know that the next year you'll be going back to school, so you'll have no income, and you will need to live off savings. Perhaps you'd be inclined to stop contributing to your tax-deferred 401K in favor of a taxable savings account. That might be a mistake. For the sake of this calculation we'll assume that you have $15,000 to save either in your 401K or in a taxable account. For the first pass calculation, we'll assume you're moving to a state that has no state income tax.

Here's how it works:

Saving Income In A Taxable Account

Remember, we're assuming that your marginal tax rate is 44%. Saving your income after tax in a taxable account will therefore cost you 44% * $15000 in taxes, for a net of $8400 in your savings account.

Saving Income In A 401K

This calculation is only moderately more complex. Since the savings is tax-deferred, you get to save the entire $15,000. When you withdraw this money the next year you pay a 10% penalty on the withdrawal, or $1500. You also pay income tax on the $15,000. The income tax calculation is $755 + 15% of the amount over $7550 ($1872.50). Thus your net is $11627.50!

Even after paying the 10% penalty, you're still far better off having put the money in your 401k, then withdrawing it once you're unemployed. In fact, it's fairly trivial to see that any time your new effective tax rate + 10% is less than your current effective tax rate (remember, your effective tax rate is different than your marginal tax rate) you are better off putting your money in the 401k, then withdrawing it after your tax rate is lowered.

Let's say that rather than move states, you stay in your current state with 9% income tax. Now if you defer the income, you’ll be paying $755 + 15% of the amount over $7550 + 9% of $15000 + $1500 penalty. Even then, that's only $3967.50 in taxes and penalties, so you're still $2632.50 ahead of paying taxes at your higher rate.

Neat, huh?