Some individuals get the nice surprise of a big tax refund every tax year (if this is you, don’t be too happy – you’ve been lending Uncle Sam money interest free). Other folks get the unpleasant surprise of having to write a big check to Uncle Sam. For the latter individuals, there may be a way to lower their tax bill and save more for retirement.
Let’s look at an example. Assume an individual has a tax bill of $4,000 and they want to reduce this. Naturally, there are other deductions they may qualify for, but in this case, they’ve
exhausted all other options except this one: saving to their 401k. Let’s also assume this individual’s marginal tax rate is 25%. The individual can take their tax rate and divide it into their tax liability for the year – in this case $4,000 divided by 25%. This comes to $16,000. Thus, if the individual wants to lower their tax liability effectively to zero, they can save $16,000 to their 401k on a pre-tax basis. This gives the effect of reducing tax liability and saving for retirement.
In another example, let’s say a couple has a liability of $9,500 and is in the 28% bracket. To reduce their liability to near zero (all else being equal) they can save $33,928 to a pre-tax 401k. Now you may be thinking that amount is way over the annual contribution limit. That’s true – on a per person basis. In other words, a married couple could split this in half and save $16,964 each to their 401ks.
This is an excellent way of having your money do double duty for you. You can reduce your tax bill and still save for retirement. In many cases, it may turn out that an individual or couple will pay less tax overall on the money deferred to the 401k since they are deferring it from a higher bracket today to a potentially lower one in retirement.
Naturally, should you have questions on this strategy, consult a competent tax professional.