Your 401K’s best friend you never knew

by: Cory Carlton

The 401K has been the main way to save since it was created in 1978. They are widely available because many companies offer them to their employees and when people enter the workforce one of the first pieces of advice they get is to start saving in a 401K.

Many financial experts agree to save in a 401K and if they are available to you, they can be very beneficial. 

The 401K is named after its tax code. Which is Title 26 Section 401k. The biggest value 401Ks offer is the tax deferral benefit of lowering your taxes now and letting you pay them when you retire.

If, and that is a big IF, you are in a lower tax bracket when you retire that will be a good deal. If you are not in a lower tax bracket, then it may cost you money in taxes in retirement than if you had paid them while you were working.

What most people don’t know is that the 401k has a friend in the same tax code book that has strengths that the 401K does not.

These are Section 7702 plans. Just flip a few pages back in Title 26 of the tax code and you find this one.

Look at this chart to see how these plans complement each other…

These two plans complement each other beautifully. They share some strengths but where the 401K has areas that would be considered compromises, the 7702 plan does not compromise in the same area. 

The tax-free and risk-free aspect of 7702 plans gives the opportunity for more income in retirement and fewer taxes due. 

Here is what this looks like in a real-life example: 

One of our new clients, who is currently 37, was starting a new job and trying to figure out how much she should save in her 401K and she wanted help understanding how it worked.

The great thing about her new employer is that they offer a match. That’s free money. We suggested she contribute to her 401K up to the match amount and we would encourage anyone to take advantage of free money. 

Anything above the match can go to the 7702 plans. Here’s why… 

She wanted to put $7,600 a year above the match and if she did that, she would save $38,922 in taxes between now and retirement. That’s the power of tax deferral and assuming she stays in the same tax bracket. 

When she retires and must start paying taxes on that money her total tax bill will be $110,013 at least. 

That means she has $71,091 of what we call “optional taxes” that she could choose to pay. 

If she saved that money in her 401K, then she would have to pay the optional taxes for a total of $110,013.

If she puts that money in a 7702 plan, she does not. She would only pay the $38,922 during her working years.

From an income standpoint, if she put her $7,600 into the 401K and retires at age 60 she will be able to expect $10,336 from the 401K a year.

If she puts that money in a 7702 plan, her annual income would be $30,876, which is tax-free.

Here’s the breakdown…

You can see why this client chose to put part of her money in a 7702 plan. You may also be thinking “Why not put all your money in a 7702 plan if the benefits are that much better?” 

That’s a good question but remember you don’t want to put all your eggs in one basket. 401Ks and 7702 work well together and are part of a complete plan.

Section 7702 plans give tax-free income, like a Roth but with no limitations, more income, reduce your taxes and eliminate various types of risk.

Not everyone will qualify for a 7702 but if you want to see what one may be able to do for you, reach out to us.

The example here was for a 37-year-old but these plans can work for people into their 60s. No matter your age and stage of life, a 7702 plan may be something to consider.

ABOUT THE AUTHOR: Cory Carlton is the CEO & Co-Founder of Both Hands FG. He specializes in strategic income planning helping people take advantage of the financial vehicles available to them. Cory, and the team at BHFG, have helped people all over the country save better for retirement by showing them how to increase their income and pay less in taxes. When Cory is not helping people plan their financial future, he is with his wife and their four children. Most likely they are outside in the woods or building something.