In Individuals, Market Outlook & Strategy

Tax Advantages of a 401k

A 401k has numerous tax features that make it a powerful structure to hold retirement assets.  If taxes rise in the future to pay for the current level of stimulus spending, these tax advantages become even more valuable.

The two most prominent tax advantaged aspects of a 401k are:

1. Pre-Tax Deferral – If you choose to contribute to a pre-tax 401k, it will reduce taxable income by the amount of the contribution.  For people in higher tax brackets, this can be a considerable tax savings.

The income tax that you would have paid on the income you put into a 401k is “deferred” until you take the money out of the account in the future, which could be decades away.  When a withdrawal is made from the account, the income is reported to the IRS and taxed as personal earnings.

The value of postponing taxes this long has significant value because the taxpayer may be at a much lower federal income tax rate once he or she retires compared to when the taxpayer was working.  Qualifying for a lower tax rate later would mean a permanent tax savings on the 401k withdrawals.

2. Tax Deferred Compounding – While the financial assets are held in a 401k, they are not taxed.  For instance, if during the last five years an investor held a mutual fund in a 401k that appreciated significantly, that investor could sell the security in the 401k and not trigger a taxable event.  This allows investors to be proactive in managing of their retirement financial assets in response to capital market conditions or investment risk tolerance changes.  This key element of the tax code allows people saving for retirement to take the necessary steps in managing risk and reward without incurring an additional tax burdens.

Therefore, it always makes sense to re-evaluate your investment portfolio and how it suits you.   This doesn’t mean you necessarily will make a change, but it re-affirms your strategy in a period of uncertainty.

If you are a participant in a 401k for Seattle small business where I am an adviser and you are still unsure if your portfolio suits you in this uncertain capital market environment, give me a call and let’s chat.  I will give you the tools to better understand investment risks and rewards which may give you more conviction in making these important retirement decisions.

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