Contribution limits for a 401(k) plan for 2017 are $18,000 per year for most people (more if you are older). Suppose you decide to contribute $12,000 per year at a rate of $1,000 per month? That’s reasonable, but if you’re like many people, the thought of giving up $1,000 a month from your take-home pay can be a little frightening.

What if it wasn’t really $1,000? What if Uncle Sam chipped in, say, $300, and your actual out-of-pocket cost to save $1,000 per month was only $700? Here’s how it works. (See also: The Basics of a 401(k) Retirement Plan.)

Tax Savings

Contributions to your 401(k) are made with pretax dollars. As that money is not subject to taxes, your taxable income is lowered, thereby reducing the hit on your take-home pay. The difference between the amount of taxes you would have paid if you didn’t make pretax contributions to your 401(k) and the amount you would pay with that money not counted is your tax savings. That’s free money, and it is perfectly legal.

Your Tax Bracket

John Bunyan (CPA/CGMA) at Donohoo, Cupp and Associates explains it like this: “The amount of your tax savings depends on your tax bracket and the amount you contribute. If your tax rate is 25%, $0.25 of every taxable dollar goes to the government, and you get to keep $0.75. For every dollar on which you don’t pay taxes, you get to keep the entire dollar.”

Bunyan created a table to show the savings for a married couple with $120,000 in gross salary and no children who take the standard deduction of $12,600 and personal exemptions of $4,050 each.

Without 401(k)

($)

With 401(k)

($)

Gross Annual Salary

120,000

120,000

401(k) Contribution

12,000

Pay Subject to Income Tax

120,000

108,000

Taxable Income (Married, Joint – no kids)

99,300

87,300

Taxes:

Social Security and Medicare

9,180

9,180

Federal Tax per Tax Tables

16,367

13,367

Estimated State/Local Taxes @5%

6,000

5,400

Total Taxes Withheld

31,547

27,947

Take-Home Pay

88,456

80,053

Reduction in Take-Home Pay

8,400

It costs only $8,400 to put $12,000 in a retirement savings account.

As Bunyan points out, your situation will likely be different, depending on the rates of your state and local taxes, your salary and any other deductions you may have.

A Couple of Caveats

Your tax savings are real and you get to keep the money – for a while. Eventually, you will have to pay taxes when you withdraw funds from your 401(k) retirement account. If you are like most people, your tax rate at retirement will be lower than during your working years. Therefore, even though you eventually have to pay taxes, they will likely be less.

If you take money out of your 401(k) before age 59½ you will pay taxes plus a 10% penalty. Also, the government requires you to begin withdrawing from your 401(k) account by April 1 of the year after you turn 70½.

More Savings for Some

If your income falls below a certain amount, you can claim an additional tax credit, known as a saver’s credit, for 10%, 20% or even 50% of your 401(k) contribution. For married taxpayers filing jointly for 2017, there’s a 50% of contribution credit for an adjusted gross income (AGI) of no more than $37,000, a 20% credit for an AGI of $37,001 to $40,000 and a 10% credit if your AGI is $40,001 to $61,500. (See also: 4 Ways to Maximize Your 401(k).)

The Bottom Line

Figuring out tax savings is easy. To determine the real cost of putting $1,000 per month (or any other amount) into your 401(k), use this calculator, which will provide an approximation showing the difference in take-home pay for any 401(k) contribution. This difference, which represents your tax savings, is money in your pocket each pay period and a reflection of the true cost of saving. Armed with this information, instead of worrying about how to get by on $1,000 per month less, work on a plan to reduce expenses by $700 or whatever the true cost of putting that money away turns out to be.

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