Tax Benefits of a 401(k) Plan

Posted by MoneySavvy on Aug 29th, 2010 | no comments home title

Planning for retirement is vitally important in a world where little if any Social Security will be available when today’s young people are ready to retire. There are many options available, such as IRAs, pensions and 401(k) retirement plans. The 401(k) is perhaps the most advantageous plan available when looking at tax benefits.

The single best benefit to you today of a 401(k) is the opportunity to put money into your retirement savings while reducing your taxable income at the same time. The money you contribute, up to a certain amount, comes out of your earnings before tax.

For example, if your paycheck before any deductions would have been $1000 and you contribute $100 towards your 401(k), Uncle Sam only gets his fingers into a percentage of $900, not the whole $1000. This means that your pay will be larger than it would be if you took $100 out of your post-tax check and put it towards savings.

The fact that your 401(k) payments are pre-tax also affects your earnings at tax time. The maximum contribution of $16,500 could be enough to kick you into a lower tax bracket if you are lucky. At the very least the amount of tax you are responsible for is going to be less.

It’s easier to report it to Uncle Sam as well, since most employers include it on your W-2. If you are instead dealing with IRAs and other forms of savings, you will have to provide all of those tax documents to your tax preparer and make sure they are each reported in the correct section of the 1040.

Another great tax benefit is the tax-free money your employer will be contributing towards your retirement. If you are contributing the full amount allowed by the IRS towards your 401(k), $16,500 in 2010, and your employer is providing a 50% match, the most common amount, you are effectively raising your per-hour earnings by at least a few dollars.

For example, if you earn $100,000 a year and contribute the maximum of $16,500 towards your 401(k) this year, your employer could contribute a match of up to 6% of your income. At 50 cents on the dollar, that would be $3000 of extra income going towards your retirement this year alone.

The final tax benefit is the opportunity to grow your retirement savings without having to pay taxes on that amount as it grows. Capital gains, dividends and other type of distributions will all be put back into your 401(k) account and allowed to grow even more without being taxed.

Remember, you will of course be paying taxes on your 401(k) when you withdraw it, but if you wait until you are at retirement age there will be no penalty and you will pay income tax based upon whatever your income is at that time. Assuming you are making less per year, then the amount of tax you pay on this income will be much lower than what it would have been when you were at the peak of your career.