This episode and next few episodes are going to be US specific episodes.
All these US specific episodes will have US flag in their thumbnails.
Indian audience, feel free to skip these episodes and save your time.
US folks, there are 2 main retirement plans in USA. 1. 401K and 2. IRA.
We will cover more in detail about IRA in another episode.
In this episode, we will cover 401K in detail.
Hi. My name is Vijay Mohan. You are watching - Investment Insights.
401K is a retirement plan offered thru employer.
We will not be able to open a 401K account just by ourself like a brokerage account.
We can contribute to a 401K, only if it is offered through our employer.
Almost all employers offer 401K plan.
Very few small companies do not offer 401K.
How much can we contribute to a 401K?
Each employee can save up to $20,500 per year.
If husband and wife both are working, both can contribute $20,500 each.
People older than 50 can contribute more - $27,000/year.
That is called as "Catch up contribution".
Other than our contribution to 401K, many employers match up our contribution up to certain percentage.
Let's say that an employer is matching up to 7%.
If our salary is $100K, 7% of that would be $7,000.
Let's say that we are contributing $20,500 to our 401k and maxing it out.
Employer would have matched up the first $7,000 of that $20,500 and would have contributed that $7,000 to our 401K.
So in total, our contribution $20,500 + employer match up contribution $7,000 = $27,500 would have gone into our 401K account.
Employer match of $7,000 would not come under the contribution limit of $20,500. This match is over that contribution limit.
In this employer match, each employer has a catch called "Vesting Schedule".
This vesting schedule defines when that extra amount matched up by the employer is going to actually credit in our account.
Let's say that an employer has a vesting schedule of 2 years, then in that 2 years, the match up amount contributed by the employer will be in our account, but not vested.
That means, if we leave the job within the 2 years of joining, then we will not get that matched up amount.
But after 2 years, that matched up amount will be ours totally, even if we leave the job.
Also, after that vesting period of 2 years, all money matched up by the employer will be vested (available) to us immediately.
That means, there will not be any restriction over the matched up money after passing 2 years.
The 2 years I am referring here is just an example. It will be different for every employer.
So what is the advantage to us from this 401K?
The advantage is, we do not have to pay the tax on the amount we are contributing to 401K.
But we should pay tax on withdrawal after retirement.
What? No tax for the contributed money, but taxed on withdrawal? What benefit does that offer to us?
Good question. To understand that, we should know about our tax bracket.
What we are seeing here is 2022 Married Filing Jointly tax bracket.
Let's say that our family income is $120,000. We will come under 22% tax bracket.
That does not mean that we will be paying 22% tax for the whole $120,000 we earned.
First 20,000 of $120,000 will be taxed at 10%.
Next 63,000 will be taxed at 12%.
Money earned over that will be taxed at 22% tax.
So the 22% tax is charged for the top most dollar we made in that year.
This is called as Marginal Tax rate.
If we add up all the taxes for individual brackets of 10%, 12% and 22%, that comes out to $17,634.
This is 14.7% of our total income $120,000.
So actually we are paying only 14.7% of our income as tax. This 14.7% is called "Effective Tax Rate".
May confuse between marginal tax rate and effective tax rate. Hope it is clear now.
So when we contribute $20,500 to our 401K, it comes out of our top most tax bracket.
That means, the tax we saved from the contribution of $20,500 is 22%. $4510.
If we withdraw the same $20,500 after our retirement, the tax rate for that would be 10%.
Tax saved for contribution is 22%, while money coming out is taxed at 10%.
The difference is 12% in our favor.
Or in other words, we save tax in marginal tax rate for contribution and we pay effective tax rate while withdrawal.
We all know that effective tax rate will be always lower than the marginal tax rate. This is first advantage.
Let's check out a sample calculation to understand the next advantage.
Let's say that our family income is $120,000. Then federal marginal tax rate is 22%.
Let's use Illinois state tax rate - 5%. For 401K contribution, not just the federal tax, we don't have to pay the state tax as well.
Let's assume that our 401K will be growing at 8% growth rate.
We are maxing out our 401K contribution every year by contributing 20,500/year.
Tax savings from this contribution is 27%. $5535.
We are continuing to do this till our retirement for 25 years.
By the end of 25 years, our 401K balance would have reached 1 million 600,000 dollars.
The $5535 that we saved every year in tax alone would have grown into $437,000.
The absolute tax saved is 5355 * 25 = $138,000.
The growth from that savings is approximately $300,000.
Or in other words, just because we did not pay (deferred) the tax of $138,000, the extra growth we got from that is $300,000.
The growth of money by deferring (not paying the tax now) the taxes to pay later is called as "Tax deferred Compounding".
This tax deferred compounding is 401K's second advantage.
For these 2 advantages, we can contribute to 401K. We should.
So far we have seen a regular pretax 401K. There are other flavors of 401K like Roth 401K and After tax 401K.
We will dig deeper into that in the next episode. Thank You.