Sunday, September 21, 2014

Using Your 401k To Get an instant 65% Returns

First off I would like to admit that my post is a little misleading. I would like to clarify that this post is not about investing in penny stocks or other risky investments to make ridiculous returns in your 401k.

However, the money you set aside in your 401k can lower your tax liability and have the same effect as getting an instant return, sometimes returns as high as 65%.

In order to get this type of treatment you must be eligible for the Earned Income Credit, the retirement savings contribution credit, and have a 401k account you can contribute to (in some cases a traditional IRA account may suffice, but not always).

Here is a hypothetical scenario:

A couple Married Filing Jointly with one dependent makes $43,250. Lets say only one spouse goes to work, and is eligible to participate in a 401k plan with their employer.

with $0 contributions to their 401k plan, the tax due by April 15th would have been $2,456 (given the 2013 tax, exemption & standard deduction rates).

With the same situation $2,000 of contributions to their 401k plan, the tax due by April 15th would now be $847. Nothing has changed, except the family has deferred $2,000 of income to save $1,609 in tax ($2,456 tax in the prior example, less the $847). The only issue becomes, can the family afford to lock up the $391 in thier 401k account to take advantage of this gain.

Note that at first glance this example appears to have an 80% return. (1,609/2,000 = 80%). The reduction in tax attributable directly to the 401k account in my opinion is not a real "return" because this money will get taxed later when you withdraw the funds at retirement. The real return comes from the increase in credit you receive with your EIC credit (increased from $0 to $309) and the credits you receive from the Retirement Savings Contribution credit (increased from $0 to $1,000). The total of $1,309 you get by contributing $2,000 to your 401k is a 65% return.

This works because when you contribute money to your 401k account your W-2 Box 1 wages are reduced. This is the amount that gets reported on your tax return. Note had you contributed your money to a traditional IRA, you would not have the benefit of reducing box 1 wages, and instead get a "for AGI deduction"** which has the chance to screw up your EIC calculation (depending on your circumstances).

The reduction in wages lowers your income that is considered for the EIC and Retirement Savings credit, which is more beneficial for lower income earners.

If you can afford to take a hit on cash flow to increase your overall wealth, I think that it would be well worth the investment now before your income rises over the years and you can no longer take advantage of these credits.

**A "for AGI deduction" is a deduction that reduces your Adjusted Gross Income, (line 37 on form 1040) which is commonly used to determine which tax payers are allowed to use certain credits such as the EIC.

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