Tax Breaks by Investing in a 401(k)

by Mark Kennan

Many for-profit companies create 401k plans to help their employees save for retirement. If you are looking for extra incentive to contribute, look no further than the tax incentives for investing in your company's 401k plan. Even though you cannot deduct the value of your contributions on your tax return, you reap equivalent benefits in other ways.

Pretax Contributions

To make a contribution to your 401k plan, your employer withholds money from your paycheck, as per your instructions. This elective deferral counts as a pretax expense, so your employer does not count the money as part of your taxable income when calculating your income tax withholding or your income subject to federal income taxes when reporting your income on your Form W-2 at the end of the year. Therefore, you effectively deduct your contributions from your taxable income before you file your income taxes.

Matching Employer Contributions

Unlike traditional and Roth IRA accounts, 401k plans allow your employer to make contributions to your plan on your behalf. When your employer puts the money in for you, it does not count as taxable income for you for that year. Instead, like your contributions, the money grows tax-free in the 401k plan until you take it out. In addition, your employer matching contributions do not count as income subject to FICA taxes.

Size of Savings

The size of your tax break based on your investment in your 401k plan depends on your marginal income tax bracket. The progressive income tax structure used by the federal government charges a higher income tax rate on larger amounts of income. Calculate your income tax savings by multiplying your tax rate by your contribution size. For example, if your effective federal tax rate is 20 percent, a $7,000 contribution saves you $1,400. You also save money on state income taxes if you live in a state that has them.

Retirement Savings Credit

When you make a contribution to a 401k plan, it also qualifies as an eligible contribution for the Retirement Savings Credit. You must also meet the other eligibility requirements, including being older 18, not being a full-time student and having your adjusted gross income fall below the annual limits for your filing status. The amount of the credit ranges from 10 to 50 percent of your contribution, with a maximum credit of $1,000 if you file a single return or $2,000 if you file a joint return.

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