Investing for retirement is fraught with potential potholes in the road. And it is often confusing since there are so many options. Knowing about these 401(k) tax benefits can make your journey to retirement a little less bumpy.
Regarding retirement, one thing is certain: investing in ways that take full advantage of tax benefits is important. Investing in only taxable accounts might sound good, since you get more flexibility in choosing how, when, and how much to invest. But the taxes can take a big bite out of your potential earnings over time. And that can have an enormous effect on your retirement years.
That’s why it’s important to invest in a 401(k) if you have the option. Not everyone does have these options, but if you’re working for an employer that offers a 401(k) plan or have your own business where you can set one up for yourself, you should definitely take advantage.
Not sure why? Here are the three main tax benefits of 401(k) plans.
Reducing Today’s Taxable Income – Traditional
When you contribute to a traditional 401(k) plan, it reduces your tax liability today. Your contributions are tax-free, so they come out of your paycheck before taxes are assessed on that check if you contribute through your employer. If you contribute to a 401(k) or a similar plan through your own business, you’ll write off the contributions at the end of the year when you calculate your taxes owed.
How much of a difference can this make? Let’s say you’re in the 22% tax bracket for 2018 and you contribute $5,000 to your 401(k) for the year. You’ll have saved $1,100 in income taxes–22% of that $5,000 contribution, if you consider that to be your top tier of income.
Contributions to a 401(k) can be particularly helpful if they push you down a tax bracket. Then the savings can be huge, since you end up paying less in taxes on your total income. If you’re hovering near the bottom income level of a tax bracket, see if you can make a contribution to your 401(k) that will push your taxable income into the next bracket down, if your employer allows this.
If you can’t make an additional contribution to your 401(k) at the end of the year, consider contributing to an IRA, instead for the same effect.
One thing to remember is that you can make contributions to tax-advantaged retirement accounts up until the tax deadline for the next year. So if you didn’t pre-plan your contributions to take your potential tax bracket into account, you have time to make some changes as you file your taxes.
Also, keep in mind the maximum contributions for 401(k) plans for that tax year. They change from year to year, with those in the over-50 age bracket allowed to make additional catch-up contributions. You can check out our annually-updated list of contribution limits here.
Social Security and Medicare
One thing to note is that pre-tax contributions to your 401(k) are still hit with Social Security and Medicare taxes. Your employer is responsible for taking this out before they pay you, and you can’t wiggle out of it. And if you run your own business, you’ll have to pay these taxes on your income, even your contributions to your 401(k) or similar plan.
Reducing Post-Retirement Taxes – Roth
Roth 401(k) plans are less typical than Roth IRAs, which you can set up as an individual. With this type of plan, the tax benefits are mainly deferred. You contribute with after-tax dollars. So contributions don’t lower your tax burden now. But when you retire, you won’t pay income taxes on withdrawals. This is a good benefit if you think you’ll be in a higher tax bracket during retirement than you are now.
With the Roth, you also get the advantage of having the account grow free from taxes on the interest you gain. This is another thing to consider when choosing between a Roth or a traditional 401(k) if you have the option. Though most people are just presented with the options their employers offer and have to choose from those options.
Other Financial Benefits of 401(k) Plans
Tax benefits aren’t the only advantage to 401(k) plans. They also have other financial benefits, besides just the benefit of your investment growing over time. Here are some of the other financial benefits you might get from your 401(k):
Matching Contributions and Profit Sharing
One of the biggest advantages to a 401(k) is when your employer gives you free money to incentivize saving. Many employers offer matching contributions when you contribute to your own 401(k). Even if you’re trying to pay off debt or meet other financial goals, you should always strive to put enough money into your 401(k) to get the full matching contribution.
Your employer may also offer profit sharing through your 401(k). Profit sharing contributions aren’t subject to Social Security or Medicare withholding, so they can be particularly helpful as a year-end bonus.
Finally, if you ever get into a financial scrape, you’ll be happy to have a balance in your 401(k). This money is protected in the event of a bankruptcy filing. So even if you don’t have enough money to pay off your debts, you can keep your 401(k) intact so long as the money stays within that account.
For all these reasons, using a 401(k) is usually a great idea. Even if you can’t afford to max it out, you can put whatever money you can afford into this account to save more for your future.
Automate Your 401(k) Plan
A more efficient way to do this is by putting your 401(k) on auto-pilot. You can do this with blooom, a robo-advisor that manages employer sponsored retirement plans. You can sign up for blooom to get a free analysis of your 401(k) and if you like what you see, you can use blooom to manage and regularly adjust your portfolio based on your goals.
Blooom costs $10 a month to manage an account. But when you consider that blooom can also save you money by finding hidden fees in your plan and acts as a fiduciary (meaning they are required by law to act in your best interests) then $10 a month begins to seem very reasonable as your 401(k) continues to grow. Learn more about blooom here.
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