For-profit employers can start 401(k) plans on behalf of their employees. By contributing to a 401(k) plan, you reap tax benefits both in the year of the contribution and as the money grows in the account. Having an understanding of how contributing to a 401(k) plan affects your taxes helps you decide if contributing is in your best financial interests.
No Write-off for Contributions
When you contribute money to a 401(k), your employer takes that money out of your paycheck and does not include it in your federal taxable income. When your employer prints your Form W-2 at the end of the year, your 401(k) plan contribution is not included in Box 1, so it does not get reported on your income. Since you never report the contributions as income, you do not get to deduct them.
Lowers Your Taxable Income
Even though you do not receive an actual deduction for your 401(k) plan contributions, the fact that you do not include them in your taxable income to begin with has the same effect. The amount that you save on your income taxes because you made a 401(k) plan contribution varies depending on your tax rate. Multiply your tax rate by your contribution to calculate your savings. For example, a $1,000 contribution saves you $150 if you fall in the 15-percent tax bracket, but $250 if you fall in the 25-percent tax bracket.
Retirement Savings Credit
You can use up to $2,000 of your 401(k) contribution to count towards the Retirement Savings Credit. The Retirement Savings Credit ranges between 10 and 50 percent of the amount you contributed. The credit percentage varies depending on your filing status and adjusted gross income. Singles have lower income limits, while married couples can have a higher income but still be eligible. To claim the Retirement Savings Credit, complete and attach Form 8880 to your income tax return.
Gains on Money in the 401(k) Plan
Technically you cannot claim a deduction for the returns you earn in the 401(k) plan. However, since the plan offers tax-sheltered growth, you do not have to report any of the income on your income tax return as long as the money remains in the account. For example, if you received $2,000 of interest income on money in your 401(k) plan in a year, you fall into the 28-percent tax bracket; if that money were in a taxable account, you would owe $560 in taxes. Since that money is in the 401(k) plan, not only do you save that $560, but the following year you have that money in the account to accrue extra returns.
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