Tap into the tax benefits of saving in a 401(k)

401(k) plans give your retirement savings special tax treatment. Most 401(k) plans allow you to contribute to your plan pretax, and some also allow you to contribute post tax—but all offer you tax benefits. Understanding the tax implications of saving in your 401(k) can help you cut your tax bill today and, possibly, over the course of your lifetime.

By law, every dollar of your salary that you contribute to your 401(k) lowers your current tax bill—up to a certain amount. To understand how this can help you, let’s begin with a quick review of federal income-tax basics.

Income taxes—the more you earn, the more you owe

How much you owe in taxes each year depends on how much you earn. It also varies with marital status and, if you’re married, depends on whether you file your taxes with your spouse or separately, what you have for deductions, and other specifics of your personal financial situation. Each year, the IRS updates the federal tax brackets that tell you what percentage you owe on every additional dollar you make. There are currently six tax brackets, with rates starting at 10% and going up to 37%. 

2021 tax year brackets for single/married filing jointly¹

2021 tax year brackets  For single taxpayers with income:  For married taxpayers filing jointly with income:
10% Up to $9,950  Up to $19,900 
12%  Over $9,950  Over $19,900 
22% Over $40,525 Over $81,050
24% Over $86,375 Over $172,750
32% Over $164,925 Over $329,850
35%  Over $209,425 Over $418,850
37% Over $523,600 Over $628,300

Sample federal incomeitax calculation

If you’re married, file jointly, and you and your spouse earn $100,000 together, you’ll owe the IRS $13,497 before deductions and credits, calculated as follows: $1,990 + $7,338 + $4,169 = $13,497.

Tax rate  On this amount of income  Adds this amount to your tax bill

10%

 First $19,900  $1,990

12%

 Next $61,150 ($81,050 – $19,900)

$7,338

22%

 Next $18,950 ( $100,000 – $81,050) $4,169

This is for illustrative purposes only. Figures are based on assumptions as set out, and individual circumstances may vary.

How saving pretax in a 401(k) helps lower your income taxes

As the example above shows, every additional dollar you earn over one tax bracket is taxed at the next tax bracket. 401(k) salary pretax contributions, by definition, come out of your paycheck before taxes, so they lower your tax bill and might also lower your tax bracket. 

Here’s how: Suppose a taxpayer and their spouse earning $100,000 and filing jointly contribute a combined total of $20,000 in salary, before taxes, into their 401(k) plans. Because contributions reduce take-home pay, the couple’s joint income for federal income-tax purposes drops from $100,000 to $80,000 (note that Social Security and Medicare taxes aren’t deferred). As a result, the couple’s income tax falls, too (from about $13,497, to roughly $9,200). The decrease in taxes is due to both less taxable take-home pay and a lower tax bracket—it falls from 22% to 12%. 

This is for illustrative purposes only. Figures are based on assumptions as set out, and individual circumstances may vary.

Congress sets the federal tax rates and brackets, and they change from time to time. But in retirement, most people have less income than while they were working—and, thus, fall into a lower tax bracket, no matter the tax rates. As a result, it may make sense for people to contribute pretax and then pay taxes on the contributions and associated earnings when they withdraw the money in retirement. This is a key benefit of 401(k) tax deferrals—potentially lower lifetime taxes, assuming that rates don’t go up across all brackets. 

How to give yourself a tax break with 401(k) contributions

In 2021, you can contribute up to $19,500 pretax, plus an additional $6,500, if you’re age 50 or older. And if you’re married, your spouse can, too; therefore, an over-50 couple could potentially contribute a combined $52,000 and reduce their taxable income by the same amount. Because 401(k) deferrals cut taxable income, dollar for dollar, this would help shrink their tax bill by over $11,400 (assuming a 22% tax bracket). 

This is for illustrative purposes only. Figures are based on assumptions as set out, and individual circumstances may vary.

The Roth 401(k)—when paying taxes now makes sense

401(k) contributions are a powerful tool to help people save for retirement, but not everyone benefits by reducing the taxes they pay today. For example, if you’re new to the workforce or if your income is temporarily low, your tax bracket may also be low. And you may want to take advantage of that by paying taxes today. Roth 401(k) contributions, if allowed by your plan, are after tax—you pay taxes on them today. You can contribute to a Roth 401(k), even if you aren’t able to contribute to a Roth IRA due to compensation limits. Then, when you withdraw your money, if you meet certain conditions—you must have a Roth 401(k) account for at least five years and be at least 59½ years old, or due to death or disability—your earnings and interest are tax free when you withdraw them. 

You should also be aware that Roth 401(k) contributions count toward the maximum of $19,500 that you can defer to your 401(k).

Early 401(k) withdrawals may increase your tax bill

Contributing to a 401(k) can help you lower your taxes. But taking money out of your 401(k) before retirement, such as through a hardship withdrawal, does the opposite. Taking money out early adds to your income and, therefore, is taxed at your highest rate. It could also move you into a higher tax bracket. So, not only do early withdrawals take money away from your retirement, they also cost you more in income taxes—and possibly carry an additional 10% penalty tax. 

So that you’re not tempted to take early withdrawals your retirement and end up paying extra in taxes, consider setting up an emergency savings account to help you meet unexpected expenses.

Shrink your taxes and help your retirement savings grow

The special tax treatment your salary and savings get with a 401(k) help make it a simple way to pay less in taxes today and get on track to be more financially prepared for retirement. 

 

1 IRS.gov, October, 2020. 2 All tax disclosures regarding Roth 401(k) contributions are limited to the federal income-tax code and, in particular, all references to tax-free treatment of qualified distributions are intended to refer to the treatment of such distributions at the federal level only.

Any tax-related discussion contained in this publication, including any attachments, is not intended or written to be used , and cannot be used, for the purpose of (i) avoiding any tax penalties or (ii) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or professional tax advisor regarding any legal or tax issues raised in this publication.

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