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Participants in a 401(k) plan make pre-tax employee contributions - also known as elective deferrals. The participant chooses to contribute a portion of pay to the 401(k) plan rather than taking the payments in cash.
The participant does not pay current federal or California state income taxes on their elective deferral, but does pay FICA and FUTA taxes.
For example:
| No 401k | with 401k |
 |
| Gross pay | 4,000 | 4,000 |
|
| 401(k) withholding | 0 | 600 |
|
| Tax withholding* | 1,440 | 1,224 |
|
| Take home pay | 2,560 | 2,176 |
|
| *assumes federal withholding of 28% and state withholding of 8% |
Your take home pay is reduced by $384 but your contribution to the 401(k) plan is $600, so your tax savings is $216. That is a current annual tax savings of $2,592.
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Contributions to a 401(k) plan do not incur taxes for capital gains, dividends and interest income as long as the funds remain in the 401(k) plan. If you invest funds outside a 401(k) plan with after-tax money, the funds do incur taxes for capital gains, dividends and interest income.
Money placed in a tax-sheltered plan offer a significantly higher return than money placed in an ordinary non-sheltered account.
If you invested $200 a month for 30 years with a 10 percent annual return before inflation:
Tax sheltered: Value of account at retirement: $413,392
Non-tax sheltered: Value of account at retirement: $242,942 (assumes a short-term capital gain rate of 28%.)
Since you do not pay current income tax on contributions to a 401(k) plan it would cost approximately 36% more to make the same contribution with after tax funds!
In other words if you earn and contribute $1 to a 401(k) plan, you must earn $1.36 in order to make a $1 contribution with after tax funds to a non-tax-sheltered account.
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