Saving In A 401(k) May Be “Cheaper” Than You Think

If you have a 401(k) at work,* you could be able to save money in your 401(k) while only reducing your paycheck by a fraction of your savings.  Most people mistakenly think that, if they have money taken out of their paycheck for their 401(k), that they will reduce their take home pay by the same amount.  Here, let me show you:

People Mistakenly Think This Is What Happens To Their Paycheck, Before and After Contributing to a 401(k).** Before After
Gross Income (per month) $3,120.00 $3,120.00
401(k) Deduction $0.00 $200.00
Taxable Income $3,120.00 $2,920.00
Federal Withholding $309.88 $309.88
Other (Social Security, Medicare, etc.) $176.28 $176.28
Net Income $2,633.84 $2,433.84
** Numbers are all made up, but meant to be approximately representative of what would actually happen.  State tax disregarded because it makes the table less intimidating.

Do you see the mistake?  By contributing to a 401(k), we reduce your taxable income.  So, not all of that $200 per month contribution comes from your net pay.  Most people forget that if we reduce your taxable income, we also get to reduce your withholding for federal and state income taxes!  So, a more accurate model of what would happen if you contributed to a 401(k) would look more like this:

This Is a More Accurate Example of What Happens To a Paycheck, Before and After Contributing to a 401(k).** Before After
Gross Income (per month) $3,120.00 $3,120.00
401(k) Deduction $0.00 $200.00
Taxable Income $3,120.00 $2,920.00
Federal Withholding $309.88 $279.88
Other (Social Security, Medicare, etc.) $176.28 $176.28
Net Income $2,633.84 $2,463.84
** Numbers are all made up, but meant to be approximately representative of what would actually happen.  State tax disregarded because it makes the table less intimidating.

The difference, in this fictional example, is that saving $200 per month in a 401(k) only “cost” $170.  That’s because there is a reduction in federal and state withholding for taxes, which is because a contribution to a 401(k) reduces your taxable income.  Nifty, huh?

So, contributing to a 401(k) may be “cheaper” than you thought!

* This may also work for other tax-deferred employer sponsored retirement savings plans.  Talk to your financial planner, tax preparer, and/or HR specialist to see if this is the case.  Also, this works in a similar but far more convoluted fashion for traditional IRAs, but talk to your financial planner or tax preparer to find out exactly how it works.

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