How Much Does My 401K Save Me In Taxes? Part 1

December 16, 2020

How Much Does My 401K Save Me In Taxes? We're glad you asked.

Our focus at Axios Capital Strategies is tax-free retirement income. While we employ many strategies, tax-free planning is our core competency. To the greatest extent possible, we strive to do that for our clients because it often means increasing net-income without increasing risk as well as increasing the longevity of retirement assets. Those are fairly important factors, in our humble opinion.

Over the next 3 parts of this post, let’s use examples to explore how pre-tax deposits into a qualified retirement plan (such as a 401K) work on both sides of the equation. In Part 4, we will go through a different scenario that improves the net-retirement income to a respectable degree by utilizing tax-free/tax-advantaged vehicles (see our post “The Tax Columns”).

In typical fashion, our posts can be a bit cynical, even snarky, from time to time. We humbly invite you to deal with it.

So many times, people simply focus on the front-end tax treatment of 401Ks or other pre-tax, qualified plans and forget (or ignore) the more important back-end tax treatment, or the “distribution planning”. This is somewhat attributed to the fact that we are a “fast food society,” wanting what we want now, upfront, with little concern for the consequences down the road. As we think you will see, this mentality when it comes to your retirement planning can be extremely detrimental.

Let’s jump in to our first example and let the math do the talking. One disclaimer: as we do these examples, we know they are not your exact situation. That’s fine. These are simplified examples to make the point. The time horizons, amounts invested, and rates of return will be for example’s sake. Get the concept, and you will see how it can apply to your situation. No matter what the numbers are, the ratios always come out relatively similar because these are financial and mathematical principles. Also, we’re not going to adjust for inflation on either side of the equation, as we normally would with a client. Using straight dollars helps to illustrate the concept more simply for this medium.

Example 1: Ryan and Jen

  • Time until retirement: 35 years
  • Annual amount to save: $6,000 pre-tax
  • Vehicle: 401K
  • Combined federal and state tax-bracket: 33%
  • Assumed annual rate of return: 7.5%

If Ryan and Jen deposit $6,000 pre-tax into a 401K with a combined tax-bracket of 33%, what is their so-called “tax-savings”?

We’re going to do some rounding for the sake of the example. Their tax-savings would be roughly $2,000 ($6,000 X .33 = ~$2,000). So, they deposited $6,000 into the 401K but it only “cost” them $4,000. That’s their “out of pocket,” after a manner of speaking. The other $2,000 they got back in tax-savings due to the nature of using a pre-tax retirement vehicle. See why everyone loves the idea of pre-tax? Well, stay tuned ...

If they deposited pre-tax $6,000 per year for 35 years, what would their total tax-savings be?

  • About $70,000. Let’s put a pin in that and come back to it.

Now, if they’ve been earning a 7.5% annual rate of return on their $6,000/yr in the 401K, what would the nest egg total be at the end of the35 years?

  • Just over $1,000,000 (35 years and one month).

At the end of the working years, here’s the picture for Ryan and Jen:

Snapshot at Retirement

401K Balance$1,000,000
Total Pre-tax Contributions$210,000
Annual Tax-savings$2,000
Total Tax-savings$70,000

Now, let’s have Ryan and Jen retire. We’re going to assume they continue to earn 7.5% on average for simplicity’s sake, but again, no matter how the variables might change, the principles (concepts) stay the same.

If they earn 7.5% on their $1,000,000 401K nest egg, let’s say they just live on the earnings or interest. So, their income would be $75,000 per year.

Being very generous, let’s assume taxes somehow don’t rise in the future ([cough] yeah right [cough]), and that they keep their combined tax-bracket of 33%.

NOTE: For a lengthy discussion on the effect of taxes on your retirement, see our post on “The Tax Columns.” You will learn why retiring to a lower tax-bracket is financial myth, why we lose deductions in retirement, and about the IRS’s “pre-tax penalty” that is offensive enough to make your skin crawl.

So, $75,000 — 33% = ~$50,000 (again, we’re rounding). That’s their net-spendable income. Therefore, taxes are roughly $25,000 per year.

Day one of their retirement, Ryan and Jen’s retirement snapshot looks like this:

Retirement Income Snapshot

Annual Rate of Return7.50%
Annual Gross Income$75,000
Annual Taxes$25,000
Annual Net-income$50,000

You might be tempted to say that’s not so bad, especially since they’re aren’t even touching their nest-egg. Let’s do some analysis and put this under the microscope.

While saving for retirement, how much in “tax-savings” did the IRS give Ryan and Jen?

  • $2,000 per year

Now in retirement, how much are they paying back the IRS?

  • $25,000 per year

What was their total tax-savings over the 35-year pre-retirement period?

  • $70,000

Now in retirement, how many years does it take Ryan and Jen to completely pay back the to the IRS all 35 years’ worth of tax- savings?

  • Less than 3

“Okay, so you’re telling me that the IRS gave me $2,000 per year in tax-savings because of using a pre-tax vehicle (401K), and that I’m paying them back $25,000 per year in retirement, when I’m on a fixed income? And that in the first 3 years of my retirement I will have paid back all my tax-savings? And I’ll continue to repay them every 3 years, again and again? Why are they called ‘tax-savings’?!?!”

You’re starting to see it, right?

If they have a 20-year retirement, how much in total taxes, in this scenario, would Ryan and Jen have paid the IRS? $500,000.

How about a 30-year retirement? $750,000.

How much did they get in “tax-savings”? $70,000.

How much do they pay back? $500,000-$750,000.

That’s a $430,000-680,000 gain to the IRS above what they provided in "tax-savings.” Oh, if only that was it. (Wait, what?) That $1,000,000 pot of money is still in the 401K and will pass to Ryan and Jen’s heirs. Guess what? Their heirs will pay income taxes on that amount. How much? Well, that’s a loaded question full of assumptions (what isn’t?), but let’s just assume 30% between combined federal and state. That means another $300,000 in taxes.

  • Total taxes generated for the IRS by the 401K: $800,000-1,050,000
  • Total tax-savings the IRS granted Ryan and Jen from pre-tax deposits into the 401K: $70,000

Whose best interest is the 401K in, anyway? It might help to remember that the 401K gets its name from where it is found in the tax code: Section 401, Paragraph K. Does "IRS” stand for Internal "Retirement” Service?

Uh, no.

Here’s a question you don’t need to think about too much. Would you invest $70,000 to get $800,000-1,050,000 back?


So would the IRS. That’s a 1,000-1,400%+ cumulative return for the IRS. Not bad, right?

And they do it all day long with their pre-tax deal. They are not stupid. They know what they are doing. With a 401K, 403b, 457, TSP, Traditional IRA, SIMPLE IRA, SEP IRA, Keogh/HR10—basically all pre-tax, tax-deferred retirement vehicles—you have a joint account. Your joint account holder is the IRS. You must understand that roughly 25-33%+ (give or take, depending on your tax bracket) of whatever your account value is does not belong to you, no matter what your statement says. It belongs to your joint account holder. And the more successful you are, the less of the account is yours. Lovely, right?

Another way to think about it is that the IRS has a mortgage or lien against your account (the inherent tax-liability). Ugh. You pay back that loan at what would be considered usury rates. Consider borrowing $70,000 over 35 years only to pay back eight- hundred thousand to over a million later. Loan shark much?

But in reality, what the IRS is doing by giving you "tax-savings” (you probably get a little queasy calling it "tax-savings" now that you understand the math better) by allowing you to save for retirement pre-tax is kicking out some of your money and inserting theirs that you will owe them back later along with all the gains it has earned alongside yours. You know, kind of like a parasite. Or a tumor.

Did you know your 401K had cancer?

See our post “4 Streams of Tax-free Income” for comprehensive scenarios on potential cures, and how to potentially get to the 0% tax bracket in retirement.

In Ryan and Jen’s case above, that $2,000 per year of tax-savings was nothing more than the IRS kicking that back to them and inputting their own $2,000 into the 401K to reap larger rewards down the road (in this example, the $25,000 per year in taxes Ryan and Jen pay in retirement).

And that assumes taxes don’t go up in the future. What if they did? The situation is more dire for Ryan and Jen, and much better for the IRS. What if Congress kills more deductions, or lets the standard deduction get cut in half (as is currently scheduled to happen January 1, 2026)? Things are worse for those who have relied on the 401K (and IRAs, etc.).

What if taxes go down in the future?

Uh, well, in that truly unlikely scenario (as an overall trend, taxes go up, not down—will the government need more or less money in the future?), the IRS still wins. If Ryan and Jen somehow magically have only a 20% combined tax-bracket in retirement, they are still paying $15,000 to the IRS every year in retirement. In less than 5 years, they’ve paid back all 35 years of so-called tax-savings. And will do so every 5 years, again and again. And the IRS still gets the taxes when the 401K passes to the heirs.

Oh, and social security taxes . . .

What About Social Security Income?

We’re going to throw one more wrench in this, and that’s social security income. Please see our post on “How Much Will My Social Security Be Taxed in Retirement?” as complementary to this section.

Recall that social security income (SSI) is tax-free on its own. Income from 401Ks (403bs, 457s, IRAs, pensions, real estate rent, capital gains, wages, etc.) count as Provisional Income (PI), thereby tainting SSI with unnecessary taxes. There are very few retirement income sources that do not count as PI, and they are powerful to use due to allowing your SSI to potentially remain tax-free (as it natively is).

The 401K’s Special Tax Bracket

So, let’s assume Ryan and Jen received $28,000/yr in SSI when they retire. Due to their 401K income, 85% of their SSI is taxable. Therefore, after taxes, their SSI is only $20,146. That additional almost $8,000 in unnecessary taxes on their SSI must be tacked on to the 401K’s tax liability. So, now the tax bill is not $25,000, but around $33,000 attributable to the nature of the 401K. Now it takes barely over 2 years to pay back all 35 years of tax-savings. Yes, you can argue that they have more income due to SSI so of course they’d pay more in tax, but their social security income does not create the additional tax. Please get this. The 401K is the culprit for the SSI being taxable, so that tax-liability falls squarely on the shoulders of the 401K (same with an IRA, 403b, 457, etc.). In essence, the 401K (and all pre-tax, tax-deferred plans) have their own tax bracket. In this example, the 401K is responsible for $33,000 in taxes due on $75,000 of income. Though Ryan and Jen are in a 33% federal and state combined tax bracket, their income from the 401K is in a 44% tax-bracket, since $33,000—the total tax attributable to the 401K—is 44% of $75,000.

Making Up The Shortfall

Since there is now an additional nearly $8,000 in taxes due, Ryan and Jen must take that extra amount out of their 401K, unless they want to accept a lesser lifestyle in retirement. How much more do they have to take out? Since 33% of $8,000 is $2,640, you might be tempted to say “$10,640 more." But that's actually a miscalculation. In order to figure out how much more Ryan and Jen would need to take out to make up for the $8,000 in additional tax, we need to use a little more math. The formula is net amount required/(1-tax bracket as a decimal). In other words, $8,000/(1-.33) = $8,000/.67 = $11,940. If you will allow me to round (thanks), Ryan and Jen essentially need to take out $12,000 more from their 401K in order to offset the roughly $8,000 of unnecessary taxes it caused on the social security income. Do you see how people can potentially run out of money faster than they thought?

You must be very cautious about saving for retirement in the IRS’s Section 401 Paragraph K plan, or any of its pre-tax siblings. Of course you should save for retirement, but where is a (if not, the) paramount question.

Please see our post on “The Tax Columns” for a deeper discussion on how taxes can affect your retirement plans.

Tax-maximization Plans

401Ks and IRAs procrastinate taxes until the future, when we all rationally believe taxes will be higher, and when we have fewer deductions to help defray the tax bite. Procrastination often has serious consequences in life, as it often does for taxes in retirement. This is why 401Ks and other pre-tax vehicles are often now referred to as “Tax-maximization Plans,” as they maximize the amount of taxes you pay over your lifetime.

How Do You Beat The IRS At Their Own Game?

One way to potentially compensate for the math benefiting the IRS is truly save the tax-savings you receive by depositing money pre-tax. Only then are they truly savings. Here’s an example:

Ryan and Jen decide to take the $2,000 per year of tax-savings and invest that into a Roth IRA or LIRP (Life Insurance Retirement Plan). Over 35 years at a 7.5% rate of return, it grows to $333,333 tax-free. So, the $70,000 they received in tax- savings over 35 years has grown to $333,333 in a tax-free environment (the Roth or LIRP).

As above, assume they continue to earn 7.5% in retirement and just scoop the interest off the top of the nest-egg. That gives them a tax-free income from this source of . . .$25,000! Thereby completely offsetting the $25,000 annual tax bill created by the 401K.


Well, sort of.

The 401K is still subject to tax increases in the future, and your SSI is still taxable (curse you Provisional income!). While this is a step in the right direction, we believe there are better scenarios to defuse the tax-bomb inside of pre-tax plans. But this can be effective. Check out “4 Streams of Tax-free Retirement Income.”

Guess how many people in all our professional years we have met that actually do this, that figure out their tax-savings from a pre-tax retirement account and invest them for the future?

Go ahead, take a guess. We’ll wait.




Not one.

Why would we save our tax-savings? That’s just crazy!

The Caveat

If your company matches at least 50% of what you contribute to a 401K, it might be worth it. The match could end up paying for the taxes on the backside. Even then you will want to do some serious math (or get professional help) in determining if and to what extent you should contribute.

Depositing more than what is required to get the full match, or where there is no match, subjects you to a likely poor mathematical outcome on the second half of the equation.

Let’s do another quick example with different parameters to illustrate that the end result, no matter the situation, is relatively similar in the end. In Part 4, we will show a possible solution that improves the net-spendable retirement income. In our post “4 Streams of Tax-free Retirement Income,” we showcase a comprehensive scenario that addresses most of these serious concerns.

Read on to Part 2.

Concerned about the tax cancer in your retirement accounts? Talk to us.