The 401K is an employer-sponsored plan that allows an individual to replenish their retirement funds in a tax-sheltered manner. The limit is set to be $18,500 for the fiscal year 2018, with a $6,000 catch-up contribution list.
The most commonly asked question regarding the 401K savings is whether they are tax deductible or not? The answer to this goes beyond a simple YES or NO.
The contributions made in the name of 401K savings can lower your annual tax liability and even the tax withheld during each pay period. However, you cannot claim tax on your income tax return for the 401(k) plan contributions. This is because you enjoy tax benefits every time you make pre-tax dollar contributions.
Let’s take a moment to understand how your 401(k) contributions actually result in tax benefits:
Lower Federal Income
Your 401(k) contributions come directly out of your salary. Being pre-tax dollars, your employer does not include these in your federal taxable income and thus your annual W-2 form reflects a lower wage than you actually earn.
Since your wages are anyway not taxable, you do not earn any deduction when filing return the said amount. And yet, your 401(k) contributions help you save by lowering your net tax liability.
Save More On Each Payday
Your 401(k) contributions also help reduce the amount of your income tax withholding.
Each time you receive your monthly payment, a certain amount is withheld by your employer for federal income tax based on your net income. But with 401(k) contributions, this amount gets reduced as a result of your income amount being reflected lower than the actual amount.
This essentially means more money in your pocket each payday.
The Saver’s Tax Credit
In addition to the savings your 401(k) contributions bring in, the IRS also offers the Saver’s Tax Credit to individuals with a Adjusted Gross Income(AGI) lower than a pre-set standard minimum amount.
This is boosted by your 401(k) contributions,as they often lower your income than the required AGI standards, thus helping you save big on your tax liability.
Misconceptions About 401(k) Savings
Your 401(k) contributions can only help with your income tax, not Social Security or even Medicare expenses. Deductions of any kind can only be claimed after these two have been assessed.
For example for an annual wage of $2,500, if you make a $400 401(k) contribution – your income tax will be charged for an amount of $2100. However, your Social Security and Medicare taxes will still be applicable to the full amount of $2,500.
We hope this article helps you make better financial decisions. For more tax-related enquires and services feel free to drop in a mail at email@example.com or dial (888)-482-0279 for an on-call consultation.