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The Tax Benefits of Your 401(k) Plan

Updated for Tax Year 2021 • August 24, 2022 04:45 PM


OVERVIEW

Your contributions to a 401(k) may lower your tax bill and help you build financial security.


For information on the third coronavirus relief package, please visit our “American Rescue Plan: What Does it Mean for You and a Third Stimulus Check” blog post.


 

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Congress created the 401(k) plan in 1986 to encourage employees of for-profit businesses to save for retirement. Two primary versions exist:

  • Tax-deferred 401(k)
  • Non-taxed Roth 401(k) introduced in 2006

Both retirement savings plans offer tax benefits and can help you build financial security for your retirement expenses, such as bills, food, and emergencies.

Tax-deferred 401(k)s reduce taxable income now

Several variations of tax-deferred 401(k)s exist:

  • SIMPLE 401(k) for businesses employing fewer than 100 people
  • Safe Harbor 401(k), in which employees always own 100% of any money their employer contributes
  • Traditional 401(k) popular with companies that have large workforces
  • One-participant 401(k) used by self-employed savers without any employees are sometimes referred to as a "Uni-k" or “Solo 401(k)."

With tax-deferred 401(k) plans, workers set aside part of their pay before federal and state income taxes are withheld. These plans save you taxes today. Money pulled from your take-home pay and put into a 401(k) lowers your taxable income so you pay less income tax now.

For example, let's assume your salary is $35,000 and your tax bracket is 25%.

  • When you contribute 6% of your salary into a tax-deferred 401(k)— $2,100—your taxable income is reduced to $32,900.
    • $35,000 x 0.06 = $2,100
    • $35,000 - $2,100  = $32,900
  • The income tax on $32,900 is $525 less than the tax on your full salary of $35,000. So, not only do you get savings for retirement, you save on taxes today.

Tax-deferred interest with 401(k)s

When you put money into a bank savings account, you pay taxes on any interest it earns every year.  But, with a tax-deferred 401(k), you don't pay taxes on the earnings as you make them every year.

For example, if you contribute $100 a month into a traditional 401(k) that earns 8%, you could amass more than $150,000 of tax-free retirement savings over 30 years and save almost $50,000 in taxes as your earnings compounded.

Withdrawal timing to save taxes

Using a tax-deferred 401(k) does not mean you never pay taxes, however. Participants pay taxes when they withdraw their earnings and contributions.

Taxable income often drops in retirement, potentially putting you into a lower tax bracket than you had as an employee. Money you take from a tax-deferred 401(k) during retirement years therefore, can get taxed at a rate lower than what you pay while fully employed.

  • Withdraw money early, though, and you will usually pay taxes plus a 10% penalty.
  • The IRS lets you begin to withdraw without a penalty at age 59 1/2, and requires you to begin withdrawing by April 1 the year after you turn 72 or after age 70 1/2 if you attained this age prior to January 1, 2020.

Roth 401(k)s reduce taxes later

Like tax-deferred 401(k)s, earnings grow tax-free in a Roth 401(k). However, the Roth 401(k) earnings aren't taxable if you keep them in the account until you're 59 1/2 and you've had the account for five years.

Unlike a tax-deferred 401(k), contributions to a Roth 401(k) do not reduce your taxable income now when they are subtracted from your paycheck. Contributions to a Roth 401(k) are after-tax contributions. You are paying taxes as you contribute, so you won’t have to pay taxes on the funds or their earnings when you withdraw the money.

  • Savers who believe their income and tax rate during retirement will be lower than while working usually opt for a traditional 401(k).
  • Those who predict they will have more income and have a higher tax rate when they retire often prefer the Roth 401(k).

Among other things, the tax savings you get with a Roth 401(k) depends partially on the difference between your tax rate while employed and your future tax rate during retirement. When your retirement tax rate is higher than your tax rate throughout your working years, you benefit tax-wise with a Roth 401(k) plan.

  • Taxpayers often have the option of funding both a Roth 401(k) and a tax-deferred 401(k).
  • The IRS adjusts the maximum contribution amount to account for cost-of-living and announces the annual limits for each type of 401(k) at least a year in advance.
  • Traditionally, the IRS has provided an additional contribution option for savers age 50 and older to enable them to prepare for their pending retirement - $6,500 in 2021.

Tax benefits for saving

Based on your income and filing status, your contributions to a qualified 401(k) may lower your tax bill even more through the Saver's Credit, formally called the Retirement Savings Contributions Credit.

  • The saver's credit directly reduces your tax by a portion of the amount you put into your 401(k).
  • Since its introduction in 2002, this credit for retirement savings has ranged from $1,000 to $2,000.
  • Eligible taxpayers calculate their credit using form 8880 and enter the amount on their 1040 tax return.

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