Three things you should know about getting a 401(k) tax deduction
Investing in a 401(k) is an attractive option for employees because it helps them save at tax time. Even though it is pretty well known that contributing to your 401(k) can help reduce your taxes, when tax season rolls around, many people are confused about how to handle their contributions. We are here to help clear up some of the misconceptions about how a 401(k) helps you save on taxes and what you should know about contributing and withdrawing.
1. 401(k) contributions are not true tax deductions
A tax deduction is an expense that you can write off if applicable, such as when a small business owner buys supplies, or when a taxpayer makes a charitable contribution. A deduction is beneficial because it lowers your tax liability by lowering your taxable income for the year the deduction is made.
When you contribute to your 401(k), you do not pay taxes but this is not the same as a tax deduction. They both achieve similar results in helping you lower your annual income tax liability. However, a 401(k) contribution does this by withdrawing the contribution amount from your paycheck before taxes are applied. This pre-tax contribution allows you to save for your retirement with Uncle Sam’s help while lowering your annual tax liability, so you do not have to pay as much in taxes for the year.
As an example, if you contribute $10,000 to your 401k and are in the 25% tax bracket you save $2500 in taxes. Thus, you are contributing $7500 and Uncle Sam is kicking in the $2500.
2. You can only take advantage of contributions up to the annual limit
This year, you can contribute as much as $19,500 to your 401(k) account, and you can contribute an additional $6,500 on top of this if you are over the age of 50. This is important to keep in mind because this is the maximum you will be able to lower your tax liability by with your 401(k) contributions. At a minimum, you should invest at least as much to the 401k that will get you the maximum match from your employer. It is almost like “free” money.
Knowing how much you will contribute and lower your liability by can help you plan for how to pay your taxes for the year and help establish financial security in retirement.
3. You pay taxes when you withdraw
Very few things in life are free. When you withdraw money from your 401k, Uncle Sam taxes it at ordinary income rates. You qualify to start withdrawing funds from your 401(k) account without penalty once you reach the age of 59 1/2 years. The benefit of waiting until now to pay taxes for most people is that:
- Your funds have been able to grow in your retirement account tax deferred.
- Your tax liability during retirement is likely going to be lower than it was when you were earning income as a full-time employee. If your tax liability is lower in retirement, your taxable income, including your 401(k) withdrawals, will be lower.
Talk to a ProVise CFP® professional about your retirement planning
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