One of my loyal readers, Jason L., wrote me and asked:"If I contribute to my company's new 401(k) program, will my take home pay go up?"
The Answer: Not Exactly. And here’s why…
Contributions to a traditional 401(k) are siphoned out of your paycheck prior to any government taxation, which is the second best benefit of the traditional 401(k) program.
The best feature of most, but not all, 401(k) program's is the employer's matching contribution. Most employers match around 3% or so. My employer matches 50% of every dollar that I contribute up to a total of 5%, which equals 2.5% total.
OMB! Note: You're literally giving up free money if you don't take your company up on this generous offer!
Now back to Jason's question...
Since your contributions to a traditional 401(k) are not taxable, your income tax expense liability that you owe to Uncle Sam every April 15th is lower, and thus your overall net income will be higher; but your actual take home pay each paycheck will still be lower.
Let’s walk through a simple example:
Scenario 1: Contribute $0 to Your 401(k)
Gross Annual Income: $50,000
Less: 401(k) Contribution: $0
Taxable Income: $50,000
Marginal Tax Bracket: 25%
Less: Taxes: -$12,500
Total Net Income: $37,500
Number of Paycheck’s Per Year: 24
401(k) Contribution Per Paycheck: $0
Take Home Pay Per Paycheck: $1,562.50
Scenario 2: Contribute $5,000 to Your 401(k)
Gross Annual Income: $50,000
Less: 401(k) Contribution: $5,000
Taxable Income: $45,000
Marginal Tax Bracket: 25%
Taxes: -$11,250
Total Net Income: $38,750 = ((($50k - $5K)*(1-25%))+$5k)
Number of Paycheck’s Per Year: 24
401(k) Contribution Per Paycheck: $200 ($5k / 24)
Take Home Pay Per Paycheck: $1,406.25 (($45k-$11.25k)/24)
What Have We Learned?
While contributing to a traditional 401(k) will increase your total income ($38,750 vs. $37,500 = +$1,250), your actual “cash in hand” from your paycheck will still be lower each pay period ($1,406.25 vs. $1,562.50 = -$156.25).
The Bottom Line
The bottom line is that a small sacrifice in monthly cash flow can reduce your overall taxes for the year and thereby increase your overall total net income. Also, if your company offers any sort of match, I personally think you’re crazy not to take their free money. These are great ways to grow your net worth.
Here are some great calculators to sensitize your personal scenarios:
http://calculators.aol.com/tools/aol/paycheck01/tool.fcs
http://finance.yahoo.com/calculator/career-work/pay-02
Thanks for the question Jason! I hope this post answers it...
Do you have question? Let me know and I will try to answer it...
OMB! Note: This was a featured post here:
http://blogs.creditcards.com/2009/01/189th-carnival-of-personal--finance.php
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