You’re Not Contributing As Much As You Think to Your 401k
By Randall | November 9th, 2007 | Category: Finance 101, Retirement | 8 comments 1,162 views | 8 Comments » |
The maximum contribution limits for 2007 for 401k’s are;
Contribution Limits:
Employee – $15,500 in 2007 and 2008. If the employee is aged 50 and over, an additional “catch-up” contribution is allowed. The additional contribution amount is $5,000 for 2007 and 2008.Employer/Employee – The lesser of 25% of compensation or $45,000 in 2007 ($46,000 in 2008).
So, as a normal employee you have $15,500 to contribute before you ‘max out’. (not including 
over 50 catch up or the self-employed).
Now let’s assume that you, the contributor gets paid 24 times per year – twice per month (those being paid every two weeks would have 26 pay periods). That works out to $645/pay period.
Wow! That’s still a pretty considerable amount to pay in each month. Here’s the beauty of the 401k though. You don’t pay this much out of your take-home paycheck!
401k Contributions are Pre-Tax Contributions
Since 401k contributions are pre-tax, the amount of money coming out of your gross paycheck is $645, but what comes out of your net paycheck is less. Here’s why.
Say you have a marginal tax rate of 28% (probably high for some of you, but I’ll go with that). That means that approx. 28% of your paycheck would go to pay income taxes anyway. Gone. Sayanora. Since the 401k contributions are pre-tax. That money isn’t included in calculating your owed tax amount.
Instead of having $645 taken out of your take-home paycheck, you only see approx. $465 taken out. That’s because the extra $180.83 was already taken out for taxes. This money ends up going into your little 401k nest egg instead of Uncle Sam’s pocket, and starts earning you money for retirement.
Sounds Good, but That’s Not All
Now we’ve taken into account Federal Taxes, but don’t forget that we also pay State Tax.
In my State, the average rate is about 4% of gross earnings, once everything is calculated out (for simplicity sake in this article). So in addition to the 28% deduction, you add the 4% deduction and you now have a total of approx. $439.17 from take-home pay. Even the state wants you to be funded for your retirement.
And Last but not Least
Now, there’s one more tax that can be applied to this little savings festival; City Tax.
If you live or work in a large city, odds are you are also paying City Tax. My City Tax comes out to an additional 1% of gross, so that would bring the grand total up to 33% (28% Federal + 4% State + 1% City) of your contribution money is being ‘given back’ by the government.
That means that the grand total for all contributions out of take-home pay to max out your 401k isn’t $645, but $432.15.
Wow.
Assuming you’ve contributed to the max. You have already made a 33% increase in profit!! By the government(s) returning money that you would have normally had to pay, you’re gaining $213.13/pay period.
If that isn’t reason enough to max out your contributions, I don’t know what is. Show me another investment that gives you a guaranteed 33% increase as soon as you buy it.
Below is a table that summarizes these savings for those with 24 and 26 pay periods.
| 24 pay periods | 26 pay periods | ||
| To Max Out in 2007/2008 | $645.83 | $596.15 | |
| Minus Federal Taxes (at 28%) | $465.00 | $429.23 | |
| Minus State Taxes (at 4%) | $439.17 | $405.38 | |
| Minus City Taxes (at 1%) | $432.71 | $399.42 | |
| Total Automatic Profit | $213.13 | $196.73 |
Act Now, While Time Still Remains
If you aren’t planning on maxing out your 401k, you still have a few more pay periods to increase your contributions before the chance goes away forever. Unlike IRA contributions, you can’t make 401k contributions for the previous year after Jan 1st of the next year.
This makes me happy!!!
I really like that way of looking at it. 
A little misleading, considering that you will eventually be taxed on the money when you finally do take it out of the 401(k) account. So this “33% profit” is temporary and forever intangible. The 401(k) account is a tax DEFERRED account, not a tax AVOIDANCE account, meaning that the participant will never see a dime of that so-called “profit”.
The real profit is the excess earnings that you collect on the “additional” 33% (minus the taxes on those earnings of course), because that is the real extra money that will eventually end up in the hands of the investor.
Using the numbers in the post, let’s say you’re putting away $300 of gross pay into your 401(k). If you weren’t putting that into the 401(k) account, you would pay 33% taxes before coming away with $200 in take home pay. If you wait for 20 years and take that same $300 out of your 401(k), you still only come away with $200 in your hands (assuming your tax bracket hasn’t changed one way or the other). Where did that supposed “profit” go? To the same place it would have gone if you hadn’t put it into your 401(k), the government. The real profit is the increased earnings you get from having those dollars in the account that would normally be used to pay taxes.
Assuming a 10% annual return, if you had put your after tax $200 into an investment account, after a year you would have $220, and that extra $20 would be taxed as income at the same rate, leaving you with about $213.40 when all is said and done. If you get that same return from your 401(k) where you were able to put in that extra $100 that normally would have gone to taxes, then you would have $330 at the end of the year. If you withdrew the $330 you would be taxed on the entire amount, leaving you with $221.10. So your actual tangible profit is $7.70 (221.10 – 213.40). So, by sacrificing $200 of take home pay to put into a pre-tax account, you gain $7.70 in real profit. That’s a 3.85% profit, which is roughly enough to keep up with inflation.
I’m not saying you shouldn’t invest in or max out your 401(k), because the alternative is worse, but to say that doing so “gives you a guaranteed 33% increase as soon as you buy it” is extremely misleading.
Though the premise of the post is true, the statements about profit and returns within the post are not.
@Chris,
Whew!! Great comment. Only one thing to add. The whole idea of the 401k is to defer taxes on it until your taxation rate is lower, as in retirement. The theory goes that you won’t be in the 33% tax bracket by the time you start withdrawing the money (age 62 1/2+ or so), so that skews the numbers to the good again.
33% savings now + accrued interest – lower taxation rate (25%?)at retirement = still better than a sharp pointy stick in the eye.
Otherwise, I’d switch to the Roth 401k (which I actually would rather do to begin with, since I’m none too sure that taxation rates won’t be HIGHER in the future regardless).
I think the rate of inflation, and the requirement that your nominal income needs to grow to keep up with it, almost ensures that your tax bracket will not be lower in retirement than it is right now. The skeptic in me thinks this on purpose, since it’s tightly controlled by a few powerful people, but I digress. Of course, I say that it will be tough to go to a lower tax bracket in retirement as a 20-something, but certainly, if you’re 60 now, you could probably knock it down a notch when you retire and maintain the same lifestyle.
But Yes, I was going to throw in my recommendation of the Roth 401(k), but the comment was already long enough.