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Example
Tommy Turtle, a slow and steady investor, makes $50,000 a year and invests 10 percent of his salary in his employer's 401(k) plan. Tommy's combined federal and state tax rate is about 40 percent, and he is 20 years from retirement. His $5,000 investment ($50,000 x .10) in the 401(k) reduces his taxable income for the year to $45,000 and he defers having to pay $2,000 of tax ($5,000 x .4) for the year. As a result, after taxes, he is left with $27,000 of disposable income for the year ($45,000 x .6).
Looking ahead and assuming similar investments earning a 6 percent annual rate of return, Tommy will have saved $100,000 in principal and made about $93,500 in tax-free interest income over the course of 20 years. Upon retirement, he will begin to be taxed on distributions made from his 401(k) plan.
Henry Hare is Tommy's co-worker and earns the same amount of money as Tommy. Henry is an overly confident investor and, unlike Tommy, decides not to invest in the 401(k) plan. Instead, he foolishly decides to just put $5,000 each year from his paycheck into a regular savings account earning 6 percent annually.
The $5,000 would have to come out of Henry's paycheck after taxes, leaving him only $25,000 of disposable income for the year [($50,000 x .6) - $5,000]. At the same time, the interest income on his savings is also taxed. As a result, Henry may save $100,000 in principal just like Tommy, but Henry's after-tax interest income comes out to less than half of the amount Tommy earns (about $46,600 to be more exact). The money Henry paid in taxes could have been earning interest for his retirement. Moreover, during the course of 20 years, Henry has $40,000 less in disposable income to spend compared to Tommy because he paid $2,000 more in taxes on his employment compensation each year. |