Although your pretax 401(k) contributions are tax deductible today, you'll eventually have to pay taxes on the money. It's important to be aware of your marginal tax bracket, because any 401(k) withdrawals that aren't rolled over into a qualified plan or IRA will be treated as regular income.
Traditional 401(k) contributions effectively reduce both adjusted gross income (AGI) and modified adjusted gross income (MAGI). The potential of tax deferral and reduction of current taxable income means that traditional 401(k) contributions offer ways to soften tax liabilities.
For example, due to federal tax savings, contributions to a qualified plan do not translate into a direct dollar-for-dollar tradeoff on take-home pay.
Additionally, if you want to reduce your taxes, contributing the maximum to a pre-tax 401(k) can be helpful. This usually applies if you're in a high-income tax bracket and have already funded other personal finance goals.
Contributions to traditional IRAs and 401(k)s are tax-deductible, and while increasing them lowers your taxable income and could increase your refund, there are contribution limits to consider.
Because contributions to traditional 401(k) plans shrink your taxable income, your taxes for the year should be reduced by the contributed amount multiplied by your marginal tax rate, as per your tax bracket.
Reduced payroll taxes
Employer 401(k) contributions aren't subject to Social Security and Medicare (FICA) taxes, meaning saving more while empowering their employees. For small business owners, this translates to lower overall payroll costs, which can be especially beneficial when managing tight budgets.
If you make contributions to a qualified IRA, 401(k), or certain other retirement plans, you may be able to take a credit of up to $1,000, or $2,000 if filing jointly. Depending on your adjusted gross income (AGI) and filing status, the Savers Credit rate may be 10%, 20%, or 50% of your contribution.
As a general rule, if you withdraw funds before age 59 ½, you'll trigger an IRS tax penalty of 10%. The good news is that there's a way to take your distributions a few years early without incurring this penalty. This is known as the rule of 55.
If you expect your tax bracket to increase, the Roth contribution option will clearly make more financial sense. If you predict the reverse, pretax contributions will benefit you more in the long run.
If you're self-employed or a small business owner, deducting business expenses is a crucial strategy to lower your AGI. Common deductible business expenses include office rent, utilities, office supplies, and more. By keeping accurate records of these expenses, you can reduce your AGI.
In the case of a Roth 401(k), you contribute with after-tax dollars. So, your employer would include your contributions in box 1 from your W-2. Whether you own a traditional or Roth 401(k), as long as you didn't take out any distributions, you don't have to do a thing on your federal or state return!
You'll owe income tax on your contributions and on your gains. So if you have a bigger income when you retire than when you made contributions, you'll be in a higher tax bracket and owe more than if you hadn't deferred your taxes.
How 401(k) Contributions Reduce Your AGI. Adjusted gross income (AGI) helps determine a person's tax liability. Because traditional 401(k) contributions are made pre-tax, they get subtracted from your paycheck before taxes. This means they can lower your total taxable income, and subsequently, your AGI.
How does a 401(k) withdrawal affect your tax return? Once you start withdrawing from your traditional 401(k), your withdrawals are usually taxed as ordinary taxable income. That said, you'll report the taxable part of your distribution directly on your Form 1040 for any tax year that you make a distribution.
You'll Enjoy More Tax Benefits
What if you max out a Roth 401(k) instead? In that case, all the money you contribute gets to grow tax-free and you won't pay any taxes on your withdrawals in retirement.
Aim for 15%
According to Fidelity, investors should aim to save 15% of their pre-tax income annually, including any match. 1 A common rule of thumb is to set aside at least 10% of your gross earnings.
The contributions you make to your 401(k) plan can reduce your tax liability at the end of the year as well as your tax withholding each pay period. However, you don't actually take a tax deduction on your income tax return for your 401(k) plan contributions.
Wealthy family buys stocks, bonds, real estate, art, or other high-value assets. It strategically holds on to these assets and allows them to grow in value. The family won't owe income tax on the growth in the assets' value unless it sells them and makes a profit.
Contribute to your retirement accounts
Traditional 401(k): Because your contributions are withdrawn from your paycheck before you've paid taxes, your taxable income will be lower, potentially reducing the federal taxes you owe for the year.
The tax advantages of a 401(k) begin with the fact that you make contributions on a pre-tax basis. That means your contributions lower your taxable income for the year. Note that this benefit applies to traditional 401(k) plans, not to Roth 401(k) plans.