You're probably already aware that you don't pay up-front taxes on the money you contribute and you don't owe taxes on your investment earnings until you withdraw the cash in retirement. Now, some were of the dissenting opinion that if you invest in your 401(k), you will end up paying more in taxes than you actually have to. Maybe on the face that looks plausible, but some financial planners disagreed - and with good reason, if you do the math. Let's say you put $10,000 in your 401(k) and invest in a stock-index fund that earns an average of 8 percent annually. After 20 years, that $10,000 is now worth roughly $46,000. If you were to withdraw that money all at once, you'd pay about $13,000 in taxes, assuming a 28 percent tax bracket, leaving you with a net income of $33,000. However, if you skip your 401(k) in favor of a taxable account, paying your taxes up front, you would have to shell out taxes on that $10,000, leaving you with only $7,200 to invest. Over the next 20 years you will have taxes on dividends and gains that the fund pays out. Even though you will get a lower rate of 15 percent when you sell out, you end up with about $28,000 net, which is about $5,000 less than the 401(k) plan would have yielded.So How's Business in regards to 401(k)s being tax traps? Bear in mind that the numbers don't factor in an employer match in your 401(k), which you are likely to get on some part of your contribution. If you add that in, a 401K is even more attractive and probably the best way to go.
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