When the government gives you an opportunity to avoid income taxes, you should take it. It's for this reason that you need to know the 401(k) limits for 2014.
How a 401(k) can save you thousands of dollars
The 401(k) plan gets its name from the corresponding section of the Internal Revenue Code, which allows wage earners to deduct their annual contribution to a retirement account before taxes.
Here's why this matters: Let's assume that Susie earns $75,000 in taxable income each year working as a manager of a local appliance store. Excluding the impact of any other deductions, Susie would end up owing the federal government $14,606 in income taxes.
By contrast, now let's assume that Susie contributes $15,000 to her 401(k), which is well below the limit for 2014. By doing so, Susie reduces her taxable income to $60,000 and thereby drives her income tax liability down to $10,856.
The immediate benefit to Susie, in other words, is a $3,750 cut to her tax bill.
|
Income Tax Line Item |
Without 401(k) contribution |
With 401(k) contribution of $15,000 |
|---|---|---|
|
Gross Income |
$75,000 |
$75,000 |
|
Taxable Income |
$75,000 |
$60,000 |
|
Tax Bill |
$14,606 |
$10,856 |
|
Savings |
$0 |
$3,750 |
Excluding the impact of all other credits and deductions. Source: author.
Taking this one step further, if you compare Susie's savings to the amount she set aside (that is, $15,000), then she effectively achieved a single-year return on investment of 25%, or nearly triple the long-run average of the S&P 500 (^GSPC 0.49%).
The point here is that it's a mistake to forgo the opportunity to get such a phenomenal return if you're in a position to do so.
So how much can you contribute?
For 2014, the limits for a traditional 401(k) are $17,500 for elective deferrals -- that is, what you choose to contribute. Additionally, your employer can match your contributions up to the lesser of 100% of your compensation or a combined $52,000.
To revisit Susie, in turn, if she elects to contribute $15,000 in 2014, then her employer could provide an additional $36,000 in funds to her retirement fund -- which, by all accounts is probably unrealistic, but you get the point.
Now, just to be clear, Susie would only be able to deduct the amount that she contributed from her 2014 income taxes. That aside, even if your employer only matches 10% of your contributions, it would still boost your overall theoretical return on investment to 35% (25% from the tax benefit plus 10% for the matching program).
The point here is that taxpayers are rarely given the opportunity to have a legal tax shelter like the 401(k). Consequently, it'd behoove you to take advantage of it to the fullest for as long as you can.
