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How Much Does My 401K Save Me In Taxes? Part 2

December 22, 2020
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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.

Retirement Snapshot

  • 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)

Conclusions

  • 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.

Concerned about how much taxes will shorten the life of your retirement assets? Talk to us.