TurboTax / Tax Calculators & Tips / All Tax Guides / Retirement / The Tax Benefits of Your 401(k) Plan

The Tax Benefits of Your 401(k) Plan

Updated for Tax Year 2014


OVERVIEW

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


Get every deduction you deserve

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

For only $54.99*
Start for Free

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 - $5,500 in 2014.

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.

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.

DAYS left
LAST DAY to file
1 DAY left
to file your taxes by April 15
2014 taxes due today
Start for Free
* Important Offer Details and Disclosures
  • Try for Free/Pay When You File: TurboTax online and mobile pricing is based on your tax situation and varies by product. Actual prices are determined at the time of print or efile and are subject to change without notice. Special discount offers may not be valid for mobile in-app purchases.
  • TurboTax CD/Download products: Price includes tax preparation and printing of federal tax returns and free federal efile of up to 5 federal tax returns. Additional fees apply for efiling state returns. E-file fees do not apply to New York state returns. Prices subject to change without notice.
  • TurboTax Mobile: Actual prices are determined at the time of print or efile and are subject to change without notice. Come back here before you file to confirm that the price has not changed, especially if it's been a while since you downloaded this app.
  • Anytime, anywhere: Internet access required; standard message and data rates apply to download and use mobile app features and content. TurboTax mobile app devices supported include Android 4.1 and above, iOS 8 on iPhone 4s and above, and iPad 2.
  • Fastest refund possible: Fastest tax refund with efile and direct deposit; tax refund timeframes will vary.
  • Pay for TurboTax out of your federal refund: A $34.99 Refund Processing Service fee applies to this payment method. Prices are subject to change without notice.
  • About our TurboTax Product Experts: Customer service and product support (phone or chat) vary by time of year. Phone support not included with Free Edition.
  • About our credentialed tax experts: Live tax advice service is available for your toughest tax questions; fees may apply. Service, experience levels, hours of operation and availability vary, and are subject to restriction and change without notice. Click here for full terms and conditions. Not available for TurboTax Business customers.
  • Get up to 10% on top of your federal refund: Amazon.com Gift Card offer is for federal refunds only. Limits apply ($2000 per e-card, maximum $10,000 per customer). Offer available only for TurboTax Online (except Federal Free Edition) or CD/download versions sold and shipped, or downloaded directly from Intuit or Amazon. Except as required by law, Amazon.com Gift Cards cannot be canceled, transferred for value or redeemed for cash.

    Amazon.com is not a sponsor of this promotion. Except as required by law, Amazon.com Gift Cards ('GCs') cannot be transferred for value or redeemed for cash. GCs may be used only for purchases of eligible goods at Amazon.com or certain of its affiliated websites. For complete terms and conditions, see www.amazon.com/gc-legal. GCs are issued by ACI Gift Cards, Inc., a Washington corporation. All Amazon ®, ™ & © are IP of Amazon.com or its affiliates. No expiration date or service fees.
  • #1 best-selling tax software: Based on aggregated sales data for all tax year 2013 TurboTax products.
  • 4.8 out of 5 stars: Average based on customer ratings on TurboTax.com for TurboTax Online and CD/download products tax year 2014, as of January 2015.
  • Most Popular: TurboTax Deluxe is our most popular product among TurboTax Online users with more complex tax situations.
  • TurboTax CD/Download priority phone support: Priority phone support for TurboTax CD/Download Premier and Home & Business is accessible exclusively via the TurboTax.com Help Center.
  • Benefit Assist: After you file, TurboTax automatically shows you a full list of government benefits you may qualify for, like Food Stamps or reduced phone & utilities. Plus, we help you apply, saving you time and making it easier than ever to get more money! Estimate based on calculation of Benefit Assist users from tax year 2013 and published reports of average benefit and savings amounts from federal and state programs. Actual amounts and qualifications based on your individual situation; some individuals will not qualify. Feature may not be available for all customers.
  • Simplified State Experience: New, simplified state tax preparation available for most filers.
  • Eligibility for $25 cash back for returning Deluxe customers: Customers who have completed their 2013 taxes in TurboTax Deluxe (CD or download), and have completed their 2014 taxes in either TurboTax Premier or TurboTax Home & Business (CD or download), and apply here before 11:59PM PDT April 20, 2015, are eligible for $25 back. 2014 TurboTax Advantage users are ineligible for this offer. Terms and conditions are subject to change without notice.
  • $0 Upgrade Offer: Valid for customers who filed their 2013 taxes with TurboTax Deluxe (CD or download), completed prior year data transfer this year, and encounter an upgrade to either 2014 TurboTax Premier or 2014 TurboTax Home & Business (CD or download). Valid February 6, 2015 through April 20, 2015. TurboTax Advantage users are ineligible for this offer. This offer may not be combined with our $25 cash back offer. Terms and conditions are subject to change without notice.