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How a 401(k) Contribution Affects Your Paycheck

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As you begin a new job, or if you are a longer-term employee who is just starting to make contributions to a 401(k) plan, you are confronted with a question:  How does a contribution to the 401(k) plan impact the final take home pay on my paycheck? Believe it or not, you could actually increase your bottom line assets by reducing your income through a 401(k) contribution.

Let’s work through an example so that we can more completely understand what happens.

Your New Job

So, you’ve started a new job, with an annual pay of $30,000.  We won’t go into all of the details behind a W4 at this point, but for the sake of the example, we’ll say you filed your W4 to exactly match your tax expected of $2,603 for the year (and you started in January).  In addition to this, you have opted to take advantage of your employer’s health insurance plan, which costs $50 per month.  You are paid on an every-other-week schedule, for 26 pay periods per year.

This means that your take-home pay amounts to approximately $884.82, which is calculated as follows:

Salary ($30,000/26)

$1,153.85

Federal withholding

$100.00

State withholding

$57.69

FICA & SS

$88.27

Health Insurance

$23.07

Net Pay

$884.82

Your 401(k)

So, you now are ready to begin making contributions to your available 401(k) plan.  The company will match your contributions as follows:

100% of the first 2% of contributions

50% of the next 2% of contributions

25% of the next 2% of contributions

If you make a total of 6% in contributions, the company will match that with 3.5% contributed to your account.  Your 6% of $30,000 will amount to $1,800 per year, and the company match will be an additional $1,050, for a total contribution of $2,850.

For each paycheck, you are making a contribution of 6%, which is $69.23, and the company’s match is an additional $40.38 added to your account.  The result in change to your paycheck will work out as follows:

 

Salary ($30,000/26)

$1,153.85

401(k) contribution

$69.23

Federal withholding

$89.71

State withholding

$54.23

FICA & SS

$88.27

Health Insurance

$23.07

Net Pay

$829.34

The difference in your final take-home pay is only $55.48, which is $13.75 less than the amount that you contributed to the 401(k) account.  This is due to the fact that when you make a contribution to the 401(k) account, this amount is no longer subject to income tax for this tax year.

When you consider what your overall economic result from this new paycheck is, you’ll see that making the 401(k) contribution is, indeed, a no-brainer:

Net pay

$829.34

401(k) contribution

$69.23

Company match

$40.38

Total economic increase

$938.95

As you can see, the end result is that you actually have increased your overall money on your balance sheet assets by $54.13, which is a 6.11% increase.  Granted, your 401(k) account and the company match are restricted in access, but your overall situation is a significant increase.

Keep in mind that, while we used 401(k) as the example type of account, the same could apply to a 403(b), or other sort of tax-deferral account.  In addition, keep in mind that your later distributions from the 401(k) will be subject to ordinary income tax.

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2 Comments

  1. Benny FitsNo Gravatar says:

    While the 401(k) is a “no-brainer” to get the company match, your statement that “…when you make a contribution to the 401(k) account, this amount is no longer subject to income tax” is incorrect, as your contribution (as well as any gains) are subject to taxation at marginal rates upon withdrawal.

    An additional consideration is the investment options available through your 401(k). The 3.5% “free” money from your employer can be considered a 3.5% additional return on funds invested. So contributing makes sense, UNLESS the investment options provide considerably less return than an outside investment.

    1. jblankenshipNo Gravatar says:

      The statement in question should have read “… this amount is no longer subject to income tax for that tax year.” I’ll update the article.

      And the comparison is against much more than 3.5% – this actually represents more than a 58% return on your contribution for the year (3.5% / 6%). An outside investment would have to gain better than 58% in order to do better than the company match.

      jb