Saving for retirement is something many people know they should do, but understanding how it can impact your taxes right now is just as important. If you have ever wondered whether your 401(k) contributions can reduce your IRS taxable income, you are not alone. The good news is that contributing to certain types of 401(k) plans can lower how much you owe in taxes today while also helping you build a financial cushion for the future. In this article, we will break down how it all works, explain the tax benefits, and show you how you can make the most of your retirement savings.
Do 401(k) contributions reduce taxable income?
Yes, contributing to a traditional 401(k) plan can reduce your taxable income. When you put money into this type of retirement plan, the contributions are taken out of your paycheck before taxes are calculated. This means the amount of money you are taxed on is lower, potentially saving you a good chunk of money now.
For example, if you earn $50,000 a year and contribute $5,000 to your 401(k), your taxable income for the year is reduced to $45,000. The IRS does not count the $5,000 you contributed as taxable income right now, though you will pay taxes on it when you withdraw the funds in retirement.
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How does a 401(k) contribution work to lower taxes?
Here is a quick breakdown of how this works:
- Pre-tax contributions: The money you put into a traditional 401(k) is contributed before income taxes are applied, which lowers your taxable income.
- Immediate savings: You pay less federal income tax in the current year since your taxable income is reduced.
- Tax-deferred growth: Your 401(k) investments grow without being taxed until you withdraw them in retirement.
Is a Roth 401(k) different?
Unlike a traditional 401(k), a Roth 401(k) does not reduce your taxable income right now. Contributions to a Roth 401(k) are made with after-tax dollars, so you are paying taxes on the money as you earn it. However, the big benefit comes later – your withdrawals, including any earnings, are tax-free as long as you follow the rules.
People often choose a Roth 401(k) if they think they will be in a higher tax bracket during retirement. For those who expect their tax rate to be lower in retirement, the traditional 401(k) might make more sense.
What are the annual contribution limits for 401(k) plans?
The IRS sets annual limits on how much you can contribute to a 401(k). For 2024, you can contribute up to $22,500 if you are under 50 years old. If you are 50 or older, you can take advantage of a “catch-up contribution” and add an extra $7,500, bringing your total limit to $30,000.
These limits apply whether you contribute to a traditional 401(k), a Roth 401(k), or both combined.
Does the saver’s credit help reduce taxes further?
Yes, if you qualify, the Saver’s Credit can further reduce your tax bill. This credit is available to low- and moderate-income individuals who contribute to retirement accounts like a 401(k). Depending on your income and filing status, you could claim a credit of up to $2,000 ($4,000 if married and filing jointly).
This is a direct credit, meaning it lowers the amount of tax you owe, making it an additional incentive to save for retirement.
When do you pay taxes on a 401(k)?
While you save on taxes now with a traditional 401(k), you will eventually pay taxes on both your contributions and the earnings when you withdraw the money in retirement. Withdrawals are taxed as ordinary income.
To avoid penalties, you can start withdrawing funds penalty-free at age 59½. However, the IRS requires you to begin taking minimum distributions by age 73 (or 72 if you reached that age before January 1, 2023).
By planning carefully, you can maximize your savings and minimize your tax liability over time.
