Getting Your Financial Ducks In A Row

How a 401k Contribution Affects Your Paycheck

Do you know how a 401k contribution affects your paycheck? Your take-home won't go down by the same amount that you defer into the 401k.

K-Line

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:  Do you know how a 401k contribution affects your 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 $1,970 for the year (and you started in January). Your state tax is a flat 5%. 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

$75.76

State withholding

$57.69

FICA & SS

$88.27

Health Insurance

$23.07

Net Pay

$909.06

How a 401k contribution affects your paycheck

So, you now are ready to begin making contributions to your available 401k 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 to your 401k, 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

401k contribution

$69.23

Federal withholding

$67.44

State withholding

$54.23

FICA & SS

$88.27

Health Insurance

$23.07

Net Pay

$851.61

The difference in your final take-home pay is only $57.45, which is $11.78 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 401k account, this amount is no longer subject to income tax for this tax year. Your taxable income went down by $1,800 and your tax went down correspondingly.

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

$851.61

401k contribution

$69.23

Company match

$40.38

Total economic increase

$961.22

As you can see, the end result is that you actually have increased your overall money on your balance sheet assets by $52.16, which is a 5.73% increase. Plus, you’re paying less income tax to boot! Granted, your 401k account and the company match are restricted in access, but your overall situation is a significant increase.

Saver’s Credit

There’s one more item that causes an economic benefit when you make a 401k contribution. The Saver’s Credit is a tax credit that you may be eligible for if your income is below certain levels. (See the article Don’t forget the Saver’s Credit for more details.)

Since in our example the employee’s income is $30,000, she is eligible for a Saver’s Credit equal to 10% of the 401k contributions for the tax year. Since she set aside a total of $1,800, this is an additional $180 to add to the bottom line. So, for the deferral of $1,800 of income, altogether our example taxpayer has had an economic benefit of $1,436 added on top of the $1,800 deferral – a fantastic return of nearly 80%!

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

Exit mobile version