Are you concerned about next year’s tax bill being too high?
Does your employer provide a 401K?
Did you know there was an easy way to lower your tax bill AND invest your money in your 401K for retirement?
Keep reading to learn more about how investing in your 401K today can help lower your tax bill for next year!
What Is a 401K?
The 401K plan is an employer-sponsored retirement plan that began in the United States in 1978.
Through this plan, millions of workers across the country can invest their earnings for their future retirement.
When you enroll in a 401K plan with your employer, a percentage of your salary is diverted to a long-term investment account.
This account is usually operated through a financial services advisory group, which allows you to invest your savings into your choice of investments.
Because the 401K plan is eligible for special IRS tax benefits, the IRS sets a contribution limit each year for how much investors can contribute to their 401K.
For current information from the IRS on the 401K plan, click here.
How Does the 401K Save Money on My Taxes?
If you have a traditional 401K, it is considered a “qualified” retirement plan, which means it is eligible for special IRS tax benefits.
Contributions you make to your 401K throughout the year can reduce your federal income tax liability at the end of the year AND your tax withholding for each pay period.
If you make a contribution to your 401K for a pay period, your contribution comes directly out of your salary. This pre-tax contribution goes straight into your 401K.
What Are the Benefits for You?
There are several benefits to making contributions to your 401K.
The most obvious benefit: you’re investing in your retirement by making contributions to your 401K! Good for you!
It also helps you that contributions to your 401K are pre-tax, which means you don’t pay any taxes on that money until you withdraw it in retirement.
Also, since this contribution decreases your taxable income, your tax withholding for that pay period also decreases. As a result, your take home pay increases by the amount of tax withholding you’re not paying. Remember to update your take-home pay when you’re updating your budget!
If you’re on the cusp between tax brackets, your 401K contributions could put you into a lower tax bracket, which means lower taxes for you.
Can You Show Me How It Actually Lowers My Taxes?
Well how kind of you to ask!
Let’s say your pre-tax salary is $35,000.
If you decide to contribute 6% of your salary during the year, you’ll contribute $2,100 ($175/month or $87.50 twice a month, depending on your pay period).
When you subtract your $2,100 contribution from your $35,000 salary, your taxable income is now $32,900.
If you were in a 22% tax bracket, your new federal income tax obligation would decrease by $462.
So now, not only have you invested $2,100 for your retirement and your future, but you’ve also saved yourself $462 on your taxes next year.
What Are the Watchouts?
There are a few watchouts with this strategy, especially because it involves the IRS and your taxes.
Since your taxable income decreases throughout the year, you won’t take a deduction when you file your taxes – but that’s because you’ve been feeling the impact of lower withholdings all year long.
You will still pay the rest of your taxes at every pay period, including state and FICA, so don’t be surprised to still see withholdings from your paycheck.
Only tax-deferred 401K contributions can contribute to your taxes, which includes traditional 401K, SIMPLE 401K, and Safe Harbor 401K. This does NOT apply to Roth 401K.
Tax benefits are only for contributions, NOT for withdrawals. You still have to pay taxes on your 401K withdrawals.