One of the most asked questions regarding 401(k) contributions is whether they are tax deductible. When planning for retirement, it is important to save efficiently and understand all the ways to maximize your nest egg. It is important to use accurate phrasing to explain the answer to this common question. There is no tax deduction for 401(k) contributions, using the actual definition of that phrase, but there are several tax benefits associated with contributing to a 401(k). Let’s examine this distinction and how you can reap these benefits.
The reason traditional 401(k) contributions are not a true tax deduction is because you don’t claim them when you fill out your tax forms. Instead, your pretax 401(k) contributions come out of your paycheck first, which then lowers your taxable income. At the end of the year, your W-2 form would show your wages subject to federal income tax were lower than you actual salary due to your pre-tax contributions. This also means your take-home pay will increase due to the reduced amount of income that is subject to income tax. The higher your income, the higher your tax bracket, therefore the more significant your tax savings when you contribute to a 401(k) plan.
There are two primary benefits to these traditional 401(k) contributions. First, putting the money into savings sooner than later could result in increasing the potential compounding returns you would see on your investment. The second benefit comes down the road when you withdraw money from your 401(k) plan. Many individuals have lower income in their retirement years than during their working years, meaning they are in a lower tax bracket. Therefore, when you are taxed on the money withdrawn from your 401(k) Plan, you pay less taxes than you’d pay on that money in the present day.
Whereas everything we’ve discussed so far is true of traditional pre-tax 401(k) contributions, the benefits change for Roth 401(k) contributions. When you make Roth contributions, taxes are deducted from the money before it goes into your 401(k) account. This means there are no tax savings in the year that the contribution is made. However, if you keep the interest/earnings in the Roth 401(k) until you’re 59 ½ and have had the account for five years, you won’t pay taxes on the deferred accumulated interest/earnings when you withdraw the money. This is ideal for those who believe their income and tax rate will be lower during their working years than their retirement years.
Additionally, there is a tax credit available to eligible individuals in the form of the IRS’s Tax Savers Credits. You must be 18 or older, not claimed as a dependent on someone else’s tax return and cannot be a student. If you meet these requirements, you can receive the credit. The specific amount is based on the adjusted gross income reported on your Form 1040 Federal Tax return, however it is typically 50%, 20% or 10% of contributions made to a 401(k), a traditional or Roth IRA, or 403(b) plan. This credit maxes out at $2,000 for individuals and $4,000 for married couples filing jointly, in 2022.
Traditional pre-tax 401(k) contributions help you save for the future while lessening the tax burden you are currently carrying. Roth 401(k) contributions are a great way to build your nest egg, knowing you will not have to pay taxes on that money when retirement comes and you begin to withdraw your retirement savings. Whether you make traditional or Roth (or both) depends on your individual financial situation, and your current tax bracket vs expected tax bracket during retirement. What is for certain, is that there are tax benefits to 401(k) contributions. It can feel overwhelming to evaluate your options and determine how to best plan for retirement. If you have questions, we are here to help. Contact RPCSI today.
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