As an employee, you might be paying between 10% to 37% of your income in taxes every year. These taxes put your take-home pay at a lower level than your gross income. However, using a 401(k) plan might allow you to reduce the taxes you pay and enable you to keep more money for your retirement.
Employees who make contributions to 401(k) plans benefit from the tax savings these accounts offer. That's why it's important to understand how much 401(k) contributions could reduce your taxes.
What is a 401(k)?
A 401(k) is a tax-advantaged retirement plan offered by many employers. Also called "defined contribution plans," 401(k)s were created as a result of the 1978 Revenue Act, which changed the tax code to allow employees to avoid paying taxes on deferred compensation.
This new rule was listed in Section 401(k) of the Internal Revenue Code. A benefits consultant named Ted Benna pointed out this rule by referring to Section 401(k) when helping a client develop a tax-friendly workplace retirement plan. Although Benna's client rejected his suggestion, the company he worked for — the Johnson Company — began offering a 401(k) plan and became the first company in the U.S. to do so.
401(k) accounts subsequently gained popularity, especially after 1981 when the IRS established new rules allowing employees to have 401(k) contributions deducted from their paychecks. Today, many employers offer 401(k) plans instead of defined benefit plans, which are better known as pensions and provided guaranteed retirement income.
401(k) plans might be cheaper and easier for employers to administer. However, the sum of money employers provide workers through 401(k) plans may depend on the sum of money each employee contributes.
How 401(k) contributions reduce your taxes
401(K) contributions could reduce your taxes in the year you invest in your workplace retirement plan. This tax reduction is the result of the IRS rules for 401(k) contributions. These rules allow you to contribute to your retirement savings using pre-tax funds, which means you don’t pay taxes on the money you invest in your 401(k).
When you contribute to a 401(k) plan, the money is taken directly from your paycheck. Employers report your wage with the contribution amount as a subtraction from your taxable income. If you earn a salary of $50,000 and contribute $5,000 to your 401(k), your taxable income will be reduced by $5,000. That means you would be taxed on $45,000 of your earnings instead of $50,000.
The specific amount you could save as a taxpayer will depend on your tax bracket. Here are the federal income tax rates for those with single filing status in the 2022 tax year (for taxes due in April 2023):
|$10,275 - $41,775||12%|
|$41,776 - $89,075||22%|
|$89,076 - $170,050||24%|
|$170,051 - $215,950||32%|
Using the example above, if you file as single and you earned $50,000 in 2022 while making a $5,000 contribution to your 401(k), you would avoid paying a 22% tax on your contribution. That means you would reduce your taxes by 22% of $5,000, or by $1,100, after making a $5,000 contribution to your 401(k).
It can get a little trickier to calculate if your retirement contribution bridges multiple tax brackets. For instance, if you file as single, made $43,000, and contributed $5,000 to your 401(k) in 2022, your entire taxable income would now be in the 12% bracket rather than partially in the 22% bracket. But the tax savings you received fall under both brackets.
The difference between your pre-contribution income at $43,000 and the cap of the lower bracket at $41,775 is $1,225. This would reduce your taxes by 22% of that $1,225 that placed you in the higher tax bracket, which is $269.50. Additionally, the remaining $3,775 contribution now belongs in the 12% bracket, saving you $453. That’s a total tax savings of $722.50 on your tax bill.
Ultimately, you may need to look at what rate the income would have been taxed at had you not been able to avoid that tax by making your 401(k) contribution. This would enable you to see exactly how much you could save. Using the best tax software might also make estimating your savings from a 401(k) contribution easy by automating the calculations for you.
Types of tax-deferred 401(k) plans
Although a 401(k) could undoubtedly save you money on your taxes, you'll need to make informed choices about what kind of 401(k) account to use. Understanding your different options is a key part of learning how to manage your money.
Here are three possible types of 401(k)s that you may be able to invest in:
- Traditional 401(k): Traditional 401(k) plans are employer-sponsored plans you could invest in by having money taken from your paycheck put into your retirement account. You'll be able to deduct your employee contributions and could select investments within your plan offerings. You may also receive employer matching contributions, which means it contributes money when you do in accordance with rules established when creating the plan. You will be taxed on withdrawals from this type of account.
- Safe harbor 401(k): Safe harbor 401(k) plans are also offered by employers, but they have different rules. Specifically, if an employer makes contributions to the account, they must be fully vested immediately. That means an employee doesn't risk losing part of their employer's contributions if they don't stay with the company for a certain minimum required length of time.
- SIMPLE 401(k): SIMPLE 401(k) plans are a retirement plan option for small businesses. They aren't subject to the same stringent nondiscrimination tests that employers must meet when establishing a traditional 401(k). In this plan type, employer contributions must always be fully vested. This plan type is available only if a company has 100 or fewer employees.
Employees don't always get to choose what kind of 401(k) they receive, but often get to decide whether to opt in or out of making contributions to the plan their company provides.
Ways to reduce taxes with 401(k) contributions
If you want to save money on your taxes and maximize your tax returns by contributing to a 401(k), there are a few techniques you could use to do it.
Increase contributions to your employer plan
The easiest way to save more on your taxes is to contribute more money to your 401(k). After all, the more pre-tax contributions you make, the more money will be subtracted from your taxable income, and the greater your savings will be.
There are, however, annual contribution limits, and you cannot exceed them. For tax year 2022, you could contribute up to $20,500 and could make an additional catch-up contribution of $6,500 if you are 50 or over.
Take a 401(k) loan
401(k) accounts have some strings attached in exchange for the tax benefits they provide. Most notably, you cannot withdraw money from your account before turning 59 1/2. If you make an early withdrawal, you'll owe a 10% penalty on top of the ordinary income tax that you pay.
If you are considering withdrawing money but don't want to get hit with extra tax, you may want to look into a 401(k) loan instead of a withdrawal. You could avoid facing taxes or a tax penalty as long as you pay back your loan on schedule, and you'd be paying interest to yourself rather than to a creditor.
Most, but not all, 401(k) plans allow loans up to $50,000 or 50% of your vested account balance, so you could access a large amount of your retirement money this way if you need it.
Withdraw at the right time
If you wait until age 59 1/2 to withdraw money from your 401(k), you could avoid the 10% early withdrawal penalty. However, you’d still be required to pay income tax on your withdrawals.
You may be in a lower tax bracket as a retiree than you were when you made your 401(k) contribution. As a result, the taxes you end up paying on withdrawals may be lower than the amount you saved by making the contributions when your tax rate was higher.
For example, you could be in the 22% tax bracket when you contributed to your account, so you’d pay 22% on your $5,000 account contributions. If you're in the 12% tax bracket and you make a $5,000 withdrawal as a senior, you would pay less income tax.
You'll also want to make sure you follow the rules for taking required minimum distributions. These are mandated withdrawals you must begin taking from your 401(k) after reaching age 72. If you do not take out the required minimum amount, you could face a tax penalty of 50% of the amount you should have withdrawn.
401(k) vs. taxable investments
The tax savings that you could achieve by making a 401(k) contribution could make this investment account an advantageous method of saving for retirement. This might be true when compared with a taxable brokerage account.
Say, for example, you have $4,680 in spare money to set aside each year for retirement. If you invest the money in a 401(k) and you are in the 22% tax bracket, you might be able to afford to contribute more than $4,680 and still end up with the same take-home pay you need.
You could, for example, invest $6,000 into your 401(k). Because you avoid taxes on the $6,000, your taxable income would still be reduced by just the $4,680 that you could afford due to the $1,320 tax credit you get.
If you put your money into a taxable brokerage account, on the other hand, you might only invest the $4,680 you could spare. You wouldn't get any tax savings as a result of your investment in this scenario.
In some cases, your employer may offer an alternative to a traditional 401(K) called a Roth 401(k). It's very important to understand the differences between a Roth 401(k) versus 401(k) as the tax savings happen at different times.
With a Roth 401(k), you do not get to take that up-front tax deduction for the contributions you make. You contribute with after-tax dollars so there are no savings in the calendar year you invest. Your $5,000 after-tax contribution would still reduce your take-home income by $5,000, but without giving you a tax break.
You could, however, take money out of your Roth 401(k) tax-free as a retiree. Because you don't pay taxes on withdrawals, you end up with more spending power from each withdrawal you make from your account. As a result, if you think your tax bracket might be higher as a retiree than it is now, a Roth 401(k) could be a better bet.
If you invest in a Roth 401(k), you also have the option to roll over the money to a Roth IRA if you choose to do so. Roth IRAs are not subject to required minimum withdrawal rules, which means you won't have to make withdrawals on the government's schedule. There are specific rules you must follow to do a rollover, though, so be sure you understand how to roll over 401(k) to IRA to avoid incurring any tax penalties.
Taking advantage of tax savings for retirement investing could enable you to build the nest egg needed for your golden years. If you aren't sure how much to invest, you may wish to talk with a financial advisor about your options. Your advisor could work with you to determine the amount you need to save for a secure future.
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