Question

YOU MAKE $125,000

After arranging your retirement money, you are planning to save money for down payment of a house purchase. Suppose your investment in 401k is tax-deductible. That means the amount you invest in 401k will be subtracted from your taxable income. Assuming your personal income tax rate is 25% roughly, how much money do you think you can save each month based on your estimation for your monthly expenses?

Answer 1

Our pretax income (or taxable income) annually is $125,000 with a tax rate of 25%

Hence tax paid if no investment is $125,000 * (0.25) = $31,250 (Equation 1)

Now, note that investment in 401k is tax deductable. Let's assume that the investment is $i

Hence now the pretax income would be $(125000-i)

Following, tax paid with investment would be $(125000-i) * (0.25) = $31,250 - 0.25i (Equation 2)

-> Tax saved = Equation 2 - Equation 1 = 31,250 - (31,250 - 0.25i) = 0.25 * i

Answer: The tax saved annually is 0.25 times the investment in 401k. For monthly tax saving we need to divide the annual tax saved by 12.

Note: Example as illustration. Let investment in 401k be $12,000 annually. Hence taxable income is $125,000 - $12,000 = $113,000. Tax paid is 0.25 * $113,000 = $28,250. Without investment tax would be 0.25 * $125,000 = $31,250 resulting in savings of $31,250 - $28,250 = $3000, the same as 0.25 * $12,000 or 0.25 * investment in 401k. Here the per month saving is $3000 / 12 = $250.