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How your 401(k) helps you defer Taxes


How Do Taxes Impact Your Number? The Power of the 401(k)

Guy Baker, MBA, MSFS, MSM, CFP, AEP

In another paper (What is your NUMBER? How Much Do I Need At Retirement), we discussed how to determine your NUMBER. Once you have your NUMBER, then you have to plan on how to reach it. This will require you to manage your income and your expenditures. (Read the paper on budgeting and paying off your debts if you are having problems in this area of your financial life.)

The formula for savings is simple – it is (INCOME – EXPENSES = SURPLUS). The question will always be, what should I do with my surplus, if I have any?  See if you know the answer to this question.


If you were to double one penny every day, how much would you have at the end of 30 days?

The answer is pretty incredible. After 10 days, your penny would have grown to $512. At the end of 20 days, it would now be worth $524,288. That is a considerable sum for certain. But who could have guessed that your penny would be worth $5,368,000 at the end of 30 days. That would be a great result, wouldn’t it?

Compounding $.01 for 30 Days

  1

.01

 

11

10.24

 

21

10,485.76

  2

.02

 

12

20.48

 

22

20,971.52

  3

.04

 

13

40.96

 

23

41,943.04

  4

.08

 

14

81.92

 

24

83,886.08

  5

.16

 

15

163.84

 

25

167,722.16

  6

.32

 

16

327.68

 

26

335,544.32

  7

.64

 

17

655.36

 

27

671,088.64

  8

1.28

 

18

1,310.72

 

28

1,342,177.28

  9

2.56

 

19

2,642.44

 

29

2,684,354.56

10

5.12

 

20

5,242.88

 

30

5,368,709.12














Of course, this is a ridiculous example. For money to double every year, you would have to earn 72% compounded. But that is not the point of this example. Read on!

Let’s add a complicating factor, taxes. What do you think your $5,368,000 would be worth if you had to pay taxes every day on the growth? Assume your tax rate was 40%. This is a high rate of tax, but it is NOT the highest if you include State income taxes. If you had to pay taxes on the gain every year, your $5.3 million dollar pot would be only worth $3.29 at the end of 30 days. WOW!!! Assume the tax rate were less? Say 20%? Now your pot of gold would be worth $10,384. Do the math if you don’t believe me.

This is the power of your IRA or 401k. You have the benefit of tax free compounding to protect your earnings and help you reach your goal. Not only do you put your money into the 401(k) without tax, it grows without tax. This is double duty - Tax free contributions and tax free growth. This is a powerful combination. Use your 401k to help you grow your money for retirement.

 

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Comment   |  6 years, 4 months ago from Irvine, CA