Getting started on your retirement savings when you're in your 20s -- or earlier -- means your money has longer to grow before you retire. Using a tax-deferred plan, like a 401(k) through your employer, lets you make those contributions with pretax dollars. Though boosting your 401(k) contribution might save you money up front, it could also cost you money in the long run.
Contributions With Pretax Dollars
When you contribute to a 401(k) plan, your employer takes out money from your paycheck and puts it into your 401(k) plan. That money isn't counted as taxable income when you file your income tax return, which saves you money. For example, say your salary for the year is $22,000 but you contribute $1,000 to your 401(k) plan. Your W-2, the form that reports your taxable income at the end of the year, will only show $21,000 of wages that are subject to income taxes.
Savings Depend on Tax Bracket
The amount that you save on your taxes depends on what tax bracket you fall into. Your tax bracket refers to the tax rate applied to your last dollar of income. The higher your tax bracket, the greater your savings with a 401(k) contribution. For example, if you're in the 10 percent tax bracket, a $1,000 401(k) contribution will only save you $100 on your taxes. If you fall in the 25 percent tax bracket, on the other hand, you'll save $250 with that same $1,000 contribution.
Taxes Only Deferred
Contributing to a 401(k) plan only defers paying taxes on income; it doesn't avoid it completely. When you withdraw the money that you put in years down the road, you must include that money as part of your taxable income in the year you take the withdrawal. For example, if you put in $1,000 today and it grows to $2,500 by the time you reach retirement, you pay taxes on the $2,500 when you take it out. So, if you're expecting to be in a higher tax bracket at retirement, you might save money on taxes now but end up costing yourself later on.
Roth 401(k) Alternative
If you're expecting to be in a higher tax bracket later in life, consider contributing to a Roth 401(k) instead of a traditional 401(k) plan, if your employer offers one. With a Roth 401(k), you don't get any deduction for making your contribution. However, when you take qualified withdrawals in retirement, the contributions and your earnings come out tax free. For example, if you put $1,000 in a Roth 401(k) when you're in the 10 percent tax bracket, you miss out on $100 of tax savings. But, if that $1,000 grows to $2,500 at retirement, you won't pay any taxes on the entire $2,500.
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