How to Properly Frame 401(k) Benefits
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Most Americans keep their retirement savings in an employer-sponsored 401(k) or in a traditional IRA that works the same way. To manage that money well, it is critical that the account’s benefits are understood: What is the net, after-tax outcome at the end of the day when you access your money? Does it save you taxes? How?
The following model of tax-shelters shows the math and logic of what happens. The example uses one set of input assumptions, but the relationships hold true for all assumptions. The benefit from the tax-shelters is calculated as the difference in outcomes versus the taxed account.
The normal taxable and Roth accounts are well understood. Both are funded with $600 after-tax savings. The Roth grows at the nominal rate of return of its investments because no profits are taxed. The taxable account grows slower because its profits are taxed. The $560 net benefit of the Roth is from sheltering profits from taxation. The 401(k) is funded with $1,000 because the $400 income tax is not deducted from wage income. The account grows tax-free. The account total is taxed at withdrawal.
How the account is funded
There is an equality of value between the after-tax $600 funding the Roth and taxable account, and the before-tax $1,000 funding the 401(k). As will be shown, not all the account is ”your money.” The same savings behavior results in each. The 401(k) needs to be larger because its dollars cannot be accessed without first paying tax. The inherent liability for withdrawal tax exists from the very start. It does not show up at the last minute.