taxes

Pay capital gains tax rate with 401(k)?

Judy O'ConnorDear Tax Talk,
Since 401(k) accounts grow over time, do 401(k)s qualify for capital gain tax breaks when you start to draw them out at retirement? Can I pay the capital gains tax rate?
-- Terry

Dear Terry,
Withdrawals from your 401(k) do not qualify for capital gain tax breaks when you start to take them out at retirement, so you can't pay the capital gains rate. However, keep in mind that they are wonderful ways to save for your retirement, as they have the benefit of tax-deferred growth over the years until you retire.

You should put as much as you can into these accounts for a lot of reasons.

Tax-deferred growth means that you have invested 100 percent of your money instead of paying tax on the earnings and then investing it.

Woman doing paperwork on laptop © Singkham/Shutterstock.com

Let's say you are in a 25 percent marginal tax bracket and put $5,000 per year in your 401(k) plan. If you instead paid the tax on the money and then invested it, you would only have had $3,750 to invest ($5,000 less $1,250 in tax paid).

As long as the money stays in the account, it can grow and you do not pay any tax on that growth until you take it out.

Let's continue the example above.

  • In year one, your $5,000 in the retirement account earns a hypothetical 5 percent, or $250. You do not pay tax on that $250 in your 25 percent tax bracket. The entire $250 is working for you, and you now have $5,250 in your account.
  • If you had not done this and instead invested your $3,750 in after-tax dollars and it generated the same 5 percent earnings, you would have earned $187.50.
  • But wait, you now have to pay tax on the $187.50 -- so now you only have $140.62 working for you. Your account balance is now $3,890.62.
  • Add this scenario up for all the years until your retirement and you will see the benefits of tax-deferred growth.

Additionally, many companies have a matching program where they will put their funds in your account on your behalf. This is a 100 percent return on your money up to the amount of the employer contribution. Who doesn't love that?

Finally, you are deferring dollars from years that you are in a higher tax bracket to your retirement years, when you will likely be in a lower tax bracket.

Thanks for the great question and all the best to you.

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