Question

Sunny contributes 15% of his $70,000 salary to a Traditional 401(k). His employer, ABC Corp., matches 75% of his contributions up to 10% of his contribution. He average tax rate is 13% and his marginal tax rate is 20%. How much is the total contribution to his 401(k) (include both his and the company's contribution) and how much would he save in taxes in the year of the contribution? A. The total contribution is $15,750 and the tax savings is $2,100 B. The total contribution is $15,750 and the tax savings is $3,150 C. The total contribution is $18,000 and the tax savings is $3,600 D. The total contribution is $18,000 and the tax savings is $2,100 E. The total contribution is $18,000 and the tax savings is $1,365 F. The total contribution is $15,750 and the tax savings is $1,365

Answer 1

The correct answer is :

Total contribution 15,750

Total tax saving 3,150

Explanatiion:

To solve the answer we need to understand 2 things:

1. Meaning of Marginal tax rate & Average tax rate

2. Meaning of this line in question ( His employer, ABC Corp., matches 75% of his contributions up to 10% of his contribution.)

First:

Marginal tax rate- It means that rate which is charged on the last amount of Income of any individual.

As we know that tax is charged on income at different rates for slab of income, so for example if person A earns 100 $ and tax rates are as follows:

0-50 $ - 10%

51-200 $ - 20%

Than in this case total tax will be 50*10% + 50*20% = 15$

Accordingly for above example average rate will be 15/ 100 = 15%(Total tax / total income)

and

Marginal rate will be 20% i.e. rate charged on last piece of income.

Based on above example we can understand that if contribution will be made to 401K fund than tax saving has to be calculated at marginal rate as income which will be taxed at 20% (as in our example) will be reduced.

Average rate given is just to confuse us and it is of no use,

Now comes the second thing - undertanding the line in question:

His employer, ABC Corp., matches 75% of his contributions up to 10% of his contribution.

This line means that ABC will make contribution equal to 75% of the contribution of employee & emoloyee contribution should be restricted to10% of the total salary. As in our case employee has contributed 15%, but the company has a limit to contribute 75% of amount upto 10% only.

Based on above explanation the answer follows as below:

Total contribution = A+B = 15750

A = Employee = 70000*15% = 10500

B = Employer = 70000*10% = 7000*75% = 5250

And

Tax savings = 15750* Marginal rate = 15750*20% = 3150

Thanks