The Tax Benefits of Your 401(k) Plan

Updated for Tax Year 2017


OVERVIEW

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


Congress created the 401(k) plan in 1986 to encourage employees of for-profit businesses to save for retirement. Two versions exist: the tax-deferred 401(k) and the Roth 401(k) introduced in 2006. Either one can help you build financial security. "Retirement savings plans such as 401(k)s offer tax benefits," says South Carolina CPA Roberta M. Floor. "You need operating money for bills and food, savings money for emergencies and distance money for retirement. A 401(k) is money for your retirement."

Tax-deferred 401(k)s reduce taxable income

Three variations of tax-deferred 401(k)s exist. The SIMPLE 401(k) for businesses employing fewer than 100 people, the Safe Harbor 401(k), in which employees always own 100 percent of any money their employer contributes, and the traditional 401(k) popular with companies that have large workforces. Traditional tax-deferred 401(k)s used by self-employed savers without any employees are sometimes referred to as "Uni-ks" or “Solo-ks."

With any tax-deferred 401(k), 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. Let's assume your salary is $35,000 and your tax bracket is 25 percent. When you contribute 6 percent of your salary into a tax-deferred 401(k)— $2,100—your taxable income becomes $32,900. The income tax on $32,900 is $525 less than the tax on your full salary. So not only do you get savings for retirement, you save on taxes today.

Tax-deferred interest with 401(k)s

You also save taxes on the earnings your traditional, SIMPLE or Safe Harbor 401(k) makes. When you put money into a bank savings account, for example, you pay taxes on any interest it earns every year. If you contribute $100 a month into a traditional 401(k) that earns 8 percent, 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 Uncle Sam when they withdraw their earnings and contributions.

As a retiree, your income often drops, 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, gets taxed at a rate lower than what you pay while fully employed.

Withdraw money early, though, and you pay taxes and a 10 percent 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 70 1/2.

Roth 401(k)s reduce post-retirement taxes

Like tax-deferred 401(k)s, earnings grow tax-free in a Roth 401(k). However, the IRS Roth 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) have no effect on your taxable income when they are subtracted from your paycheck. That’s because the funds are removed after taxes, not before. This means you are effectively paying taxes as you contribute, so you won’t have to pay taxes on the funds when you withdraw.

Savers who believe their income during retirement will be low usually opt for a traditional 401(k). Those who predict they will have more income and fall under a higher tax bracket when they leave the workforce prefer the Roth 401(k).

Among other things, the tax savings you get with a Roth 401(k) depends 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 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 agency has provided an additional contribution option for savers age 50 and older to enable them to prepare for their pending retirement - $6,000 in 2017.

Tax benefits for saving

Based on your income and filing status, your contributions to a qualified 401(k) may lower your tax bill more through the saver's credit, or retirement savings contributions credit. "The income ceiling amounts are set low as an enticement for lesser-income taxpayers to put money aside for retirement," says Floor.

The saver's credit directly reduces your taxable income by a percentage 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.

"Some wonder if they can afford to save 2 percent for retirement and still pay their bills, when the better question might be, "How can I reduce my bills by 2 percent and save?" says Floor.

Get every deduction you deserve

TurboTax Deluxe searches more than 350 tax deductions and credits so you get your maximum refund, guaranteed.

For only $59.99$39.99*
Start for Free

Looking for more information?

The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.


Security is built into everything we do
Here's how
* Important Offer Details and Disclosures
  • TURBOTAX ONLINE/MOBILE

  • Try for Free/Pay When You File: TurboTax online and mobile pricing is based on your tax situation and varies by product. Absolute Zero $0 federal (forms 1040EZ/1040A) + $0 state limited time offer only available with TurboTax Free Edition; offer may change or end at any time without notice. Actual prices are determined at the time of print or e-file and are subject to change without notice. Savings and price comparisons based on anticipated price increase. Special discount offers may not be valid for mobile in-app purchases.
  • QuickBooks Self-Employed Offer with TurboTax Self-Employed: To receive your complimentary subscription to QuickBooks Self-Employed through 4/30/19, you must pay for your 2017 TurboTax Self-Employed return by 4/17/18 and sign-in and access your QuickBooks Self-Employed account via mobile app or at https://selfemployed.intuit.com/turbotax at least twice by 7/15/18. You will have the option of renewing your QuickBooks Self-Employed subscription by 4/30/19 for another year at the then-current subscription rate. You may cancel your subscription at any time from within the QuickBooks Self-Employed billing section. See QuickBooks.com for price comparison. Offer not valid for existing QuickBooks Self-Employed subscribers already on a payment plan.
  • Pays for itself (TurboTax Self-Employed): Estimates based on deductible business expenses calculated at the self-employment tax income rate (15%) for tax year 2017. Actual results will vary based on your tax situation.
  • Anytime, anywhere: Internet access required; standard data rates apply to download and use mobile app.
  • Fastest refund possible: Fastest tax refund with e-file and direct deposit; tax refund time frames will vary.
  • Pay for TurboTax out of your federal refund: A $X.XX Refund Processing Service fee applies to this payment method. Prices are subject to change without notice.
  • TurboTax Help and Support: Access to a TurboTax specialist is included with TurboTax Deluxe, Premier, Self-Employed and TurboTax Live; not included with Free Edition (but is available as an upgrade). TurboTax specialists are available to provide general customer help and support using the TurboTax product. SmartLook on-screen help is available on a PC, laptop or the TurboTax mobile app. Service, area of expertise, experience levels, wait times, hours of operation and availability vary, and are subject to restriction and change without notice.
  • Tax Advice, Expert Review and TurboTax Live: Access to tax advice and Expert Review (the ability to have a Tax Expert review and/or sign your tax return) is included with TurboTax Live or as an upgrade from another version, and available through October 15, 2018. These services are provided only by credentialed CPAs, EAs or tax attorneys. State tax advice is free. Some tax topics or situations may not be included as part of this service, which shall be determined in the tax expert’s sole discretion. In the event your return is reviewed by a tax expert and requires a significant level of tax advice or actual preparation, the tax expert may be required to sign your return as the preparer at which point they will assume primary responsibility for the preparation of your return. Expert Review [and TurboTax Live] not available on the TurboTax mobile app or when using a web browser on your mobile phone. On-screen help is available on a PC, laptop or the TurboTax mobile app. Service, area of expertise, experience levels, wait times, hours of operation and availability vary, and are subject to restriction and change without notice.
  • Tax Return Access and My Docs features: Included with TurboTax Deluxe, Premier, Self-Employed, TurboTax Live or with PLUS benefits. Access to all tax-related documents we have on file for you is available through 10/31/2019. Terms and conditions may vary and are subject to change without notice.
  • #1 best-selling tax software: Based on aggregated sales data for all tax year 2016 TurboTax products.
  • Most Popular: TurboTax Deluxe is our most popular product among TurboTax Online users with more complex tax situations.
  • CompleteCheck: Covered under the TurboTax accurate calculations and maximum refund guarantees.
  • #1 rated online tax prep provider: Based on independent comparison of the best online tax software by TopTenReviews.com March 13, 2017.
  • Get tips based on your tax and credit data to help get you to where you want to be: Tax and credit data accessed upon your consent.
  • TURBOTAX CD/DOWNLOAD SOFTWARE

  • TurboTax CD/Download products: Price includes tax preparation and printing of federal tax returns and free federal e-file of up to 5 federal tax returns. Additional fees apply for e-filing state returns. E-file fees do not apply to New York state returns. Savings and price comparison based on anticipated price increase. Prices subject to change without notice.
  • Fastest refund possible: Fastest tax refund with e-file and direct deposit; tax refund time frames will vary.
  • Pay for TurboTax out of your federal refund: A $X.XX Refund Processing Service fee applies to this payment method. Prices are subject to change without notice. This benefit is available with TurboTax Federal products except TurboTax Business.
  • About our TurboTax Product Experts: Customer service and product support vary by time of year.
  • About our credentialed tax experts: Live tax advice via phone is included with Premier and Home & Business; fees apply for Basic and Deluxe customers. State tax advice is free. Service, experience levels, hours of operation and availability vary, and are subject to restriction and change without notice. Not available for TurboTax Business customers.
  • #1 best-selling tax software: Based on aggregated sales data for all tax year 2016 TurboTax products.
  • Data Import: Imports financial data from participating companies; may require a free Intuit online account. Quicken and QuickBooks import not available with TurboTax installed on a Mac. Imports from Quicken (2016 and higher) and QuickBooks Desktop (2012 and higher); both Windows only. Quicken import not available for TurboTax Business. Quicken products provided by Quicken Inc., Quicken import subject to change.