Updated for tax year 2023.
With tax season coming soon, you may be wondering how you can reduce your taxable income. One smart place to start looking is your 401(k) plan. Here are a few ways your 401(k) can reduce your taxable income and save you money.
At a glance:
- There are different types of tax-deferred 401(k)s.
- Contributions are deducted from your paycheck before taxes, lowering your taxable income and resulting in reduced taxes paid overall.
- Instead of hardship withdrawals with penalties and taxes, consider 401(k) loans for financial hardships.
What is a 401(k) plan?
The 401(k) plan was passed by Congress in 1986 to help employees save money for retirement. Employees can contribute to a retirement account on a pre-tax basis, encouraging them to save more money for the future. Many employers even offer to match employee contributions up to a certain percentage, giving employees even more incentive to sock money away for retirement.
Nowadays, most employers offer some type of 401(k) plan to their employees. In turn, plan participants can take advantage of the many tax advantages a 401(k) provides.
Types of tax-deferred 401(k)s
Not all 401(k)s are the same. In fact, there are three different types of 401(k)s for traditional employees.
First, there is the traditional 401(k), which is common among larger employers. Next, there is the SIMPLE 401(k), which is available for companies with fewer than 100 employees. Lastly, there is the Safe Harbor 401(k), which allows employees to take 100% ownership of any employer retirement contributions.
And you don’t have to work for an employer to take advantage of tax benefits from a 401(k). Entrepreneurs, contractors, and freelancers who are self-employed also have the option to open a Solo 401(k).
Lowering your taxable income with a 401(k)
So how do 401(k)s provide tax advantages to you? As an employee participating in any tax-deferred 401(k) plan, your retirement contributions are deducted from each paycheck before taxes are taken out. Since 401(k)s are taken out on a pre-tax basis, it lowers your taxable income, resulting in fewer taxes paid overall.
For instance, say you make $40,000 annually through an employer. Let’s assume 25% of your take-home pay goes to taxes annually. That results in you paying $10,000 in taxes each year, which in turn reduces your take-home pay to $30,000.
But say you want to start contributing 5% of your pay into your employer-sponsored 401(k) plan. Five percent of a $40,000 annual salary results in $2,000 saved for retirement in a year. Since that $2,000 was deducted pre-tax, your total taxable income lowers to $38,000. At the same 25% tax bracket, you now only owe $9,500 in taxes, saving you $500 annually on your tax bill. Plus, you saved an additional $2,000 money for retirement, making that one sweet deal all around.
Save on interest earned from 401(k) accounts
If reducing your taxable income wasn’t enough, by contributing to a 401(k), you also reduce your taxes on the interest earned from your contributions. Unlike money stored in the bank, you don’t have to pay taxes on money earned from your 401(k) investments.
Increase contributions to your employer plan
One of the easiest ways to reduce your taxable income is to contribute more to your retirement account. You can easily do that by adjusting your contribution amount through your paycheck if you are involved in an employer’s 401(k).
Usually, you can simply log in to your retirement account and increase your contributions. You can set your contribution to have a specific amount of each paycheck added to your 401(k) account, or you can have a certain percentage of your paycheck taken out.
Since 401(k) contributions are pre-tax, the more money you put into your 401(k), the more you can reduce your taxable income. By increasing your contributions by just 1%, you can reduce your overall taxable income, all while building your retirement savings even more.
Take a 401(k) loan versus a hardship withdrawal
No matter how prepared you may be, financial hardships do occur. During tough times, many people turn to the money they have saved in their 401(k) accounts. Unfortunately, withdrawing money from your 401(k) before you are age 59 ½ has some expensive consequences.
To take a hardship withdrawal from your 401(k), your financial situation must first meet a specific set of criteria as specified by the IRS. If your request for withdrawal is approved, you must then pay federal and state income tax on the amount taken out of your account. You must also pay a 10% penalty fee for early withdrawal.
Instead of withdrawing money from your retirement account, you can consider taking a 401(k) loan instead. Unlike hardship withdrawals, loans must be paid back. But 401(k) loans are not taxable, so they aren’t as damaging to your finances as a hardship withdrawal.
Not all employer plans allow 401(k) loans, so be sure to check with your company’s 401(k) administrator for all the details ahead of time.
Withdraw at the right time
Though 401(k) contributions are on a pre-tax basis, that doesn’t mean you get away without ever paying taxes on your savings. Instead, you pay taxes when you withdraw your earnings.
While that may sound like a major drawback, you still reap benefits by contributing to a pre-tax account now. As you reach retirement age, your income is most likely going to drop as you stop working. In turn, that puts you into a lower tax bracket than you had when you worked full-time. That means that, as a retiree, the money you take out of your 401(k) is likely to be taxed at a much lower rate.
If you withdraw funds from your 401(k) before age 59 ½, however, you are then subject to a 10% penalty as determined by the IRS. The penalties for early withdrawal are there to encourage participants to continue to build their 401(k) savings at a healthy rate, allowing them to eventually leave the workforce and enjoy retirement.