How Much Does My 401K Save Me In Taxes? Part 2Submitted by Axios Capital Strategies on December 22nd, 2020
In Part 1, we put forth an example of the full equation of saving for retirement with our example couple, Ryan and Jen. We saw that all the tax-savings they achieved by saving for retirement in a pre-tax manner (through a 401K) are paid back to the IRS every three years or so in retirement.
Now, let’s look at a different scenario to show just how similar the end results are regardless of time horizon, amount being invested, rate of return, etc. As before, this is a simplified scenario using straight dollars (not inflation adjusted) to illustrate the principle. Remember, everything is proportional and designed to benefit the IRS.
Example 2: Max and Trisha
- Time horizon until retirement: 20 years
- Annual amount to save: $16,000 pre-tax
- Vehicle: 401K
- Combined federal and state tax-bracket: 25%
- Assumed annual rate of return: 8%
Since we took the time in Part 1 to break down the example step-by-step, we’re going to move a bit faster now. Pre-retirement Snapshot
- Annual $16,000 pre-tax deposit produces a “tax-savings” of $4,000 per year ($16,000 X 25% tax-bracket = $4,000)
- Over 20 years, total tax-savings is $80,000
- Retirement nest-egg grows to ~$800,000 at 8% rate of return (after 20 years and a month, essentially)
As before, let’s assume that Max and Trisha can earn 8% per year during retirement on their nest-egg, and that taxes magically don’t rise (for example’s sake), leaving them at their combined 25% bracket.
- 401K nest-egg value: $800,000
- Gross retirement income from 401K: $64,000
- Taxes owed: $16,000 (25% tax-bracket)
- Net retirement income: $48,000
- Social Security Income: 85% taxable (thanks to the 401K income qualifying as Provisional Income)
- Max and Trisha’s annual tax-savings due to pre-tax deposits: $4,000
- Annual amount they repay the IRS: $16,000 (400% return to the IRS), not including the extra taxes on their SSI caused by the 401K
- Max and Trisha’s total tax-savings over 20 years: $80,000
- Number of years to pay pack all 20 years of tax-savings ($80,000): 5
- Total taxes paid over 20-year retirement: $320,000
- Total taxes paid over 30-year retirement: $480,000
- Additional taxes the IRS gained above tax-savings they provided: $240,000-400,000
- Approximate amount of taxes owed by heirs ($800,000 401K nest-egg passed on): perhaps 20-35%, depending on how they take it and their tax-brackets. Regardless, taxes are still owed on the 401K nest-egg. That means another $160,000-280,000 in taxes. Now the IRS stands to collect a total of $480,000-$760,000 by virtue of the $80,000 investment (the pre-tax tax-savings) they made in Max and Trisha. That’s $400,000-680,000 more that the tax-savings they granted Max and Trisha from their pre-tax retirement deposits.
No matter what the pre-retirement numbers are, we almost always find that the time period to payback the IRS is around 3-6 years (using reasonable assumptions). Let’s look at one more scenario in Part 3 before we look at a potential solution in Part 4.
Read on to Part 3.