2015 Resolution: Pay Less Taxes by Upping 401(k) Contribution

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In 2015, the federal government is giving many workers a gift in the form of a generous but underused tax break. Your new year's resolution should be to take advantage of it.

If your workplace offers a retirement plan such as a 401(k), 403(b) or Thrift Savings Plan (for federal government workers), beginning in 2015 you'll be able to contribute as much as $18,000 per year ($24,000 if you are 50 or over).

Save More in Order to Pay the Tax Man Less

It's always annoying to see how much money is withheld from your paycheck for taxes. It is especially lousy if you live in a high-tax state such as California, Oregon, Minnesota or New York. For example, if you are a California resident and you and your spouse earned a combined income of $150,000 or more, it's possible that at least 37 percent of your paycheck goes toward paying federal and state income taxes. Is there a way to keep 100 cents for every dollar you earn instead of only 63 cents? Yes, by contributing those dollars to your retirement account.

It surprises me how few people who are eligible for (and can afford) this tax break leverage it to its fullest extent. According to Vanguard's How America Saves 2014, Vanguard found that only 12 percent of participants in the retirement plans it manages maxed-out on their contributions. Saving $18,000 a year may seem too draconian for someone who wants to live for today, but in the California example above, it means saving only approximately $11,340, because after state and federal taxes, that's what going to be left in your paycheck out of $18,000 in earnings.

Become a Millionaire Faster by Contributing the Maximum

As I wrote in The Five Rules that Helped Me Become a Millionaire Before 40, contributing the max to my retirement plan was one of those important rules. And to do so, I had to live more frugally than most of my friends and co-workers with similar incomes. How did I not succumb to "keeping up with the Joneses" disease? Because I was confident that at age 60 I would be living a life of leisure while they would still be working.

While low-income workers cannot be expected to max out their retirement contributions, there is little reason why middle and high-income workers cannot, especially if student loans are paid off. And if you can't contribute the max to your retirement plan because of a high mortgage payment or credit card balance, maybe it's time to downsize and live a simpler life.

Assume you are 35 and contribute $1,500 per month to your workplace retirement account and invest it in a low-fee mutual fund that mirrors the S&P 500 (^GPSC). Historical performance is no guarantee of future performance but on average, the S&P 500 returns about 8 percent annually. If you start at age 35, at age 60, you're likely to have close to $1.5 million in that account. And if you prefer to dial down risk by investing in a combination of stocks and bonds, you're still likely to hit the $1 million mark. Imagine if your spouse does the same. Two ways to get there faster: 1) work for an employer who matches part of your contribution; and 2) start contributing in your 20s or early 30s.

Still finding it hard to stomach that you won't be able to access that money until retirement? At 59½, you can start withdrawing the money with no penalty (although you are not required to do so until 11 years later). You'll pay income taxes on whatever you withdraw each year. But by then, perhaps you will have moved to a state with no state income tax like Florida or Texas. Believe me, 60 will be here closer than you think. If you need money before retirement, in certain cases you can take a loan from your 401(k) or withdraw money in times of hardship. You can also cash it out by paying a 10 percent penalty if you are really desperate.

So take advantage of the retirement plan tax break and get yourself to millionaire status before the Joneses do.

The information contained herein is strictly for educational and illustrative purposes, providing commentary, analysis, opinions, and recommendations and should not be considered investment advice for any specific subscriber or portfolio or an offer to sell or a solicitation to buy any security.
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