How Does A 401K Affect Your Yearly Taxes?

How does a 401k affect your yearly taxes? The original concept behind the 401k plan was to take advantage of tax law and to save working people from paying more tax than they need to. "The tax savings are,...

"The tax savings are, of course, one of the biggest advantages and most popular features of the 401k plan" explains tax expert and investment analyst Paul Dlouhy. In fact, the original concept behind the 401k plan was to take advantage of tax law and to save working people from paying more tax than they need to - when the 401k was proposed, surprisingly the IRS was amenable to the idea. The tax breaks are still huge - according to the Congressional Joint Committee on Taxation, the tax benefits of 401k plans costs the federal government more in tax revenue than any other tax deduction, and that includes the mortgage deduction.

The money that you contribute to a 401k plan comes out of your pay before income tax is calculated, meaning an employee is exempt from federal income taxes on the amount of money they put into their 401k, plus the proceeds until withdrawal. This applies to your taxes even if you don't itemize deductions and take the standard deductions. A 401k is not exempt from Social Security and Medicare taxes, and in most cases state taxes.

Investment analyst Paul Dlouhy illustrates how this can work "As an example of the money that can be saved during the year, if an employee earns $50,000 in a year and deposits $3000 into their 401k account during that year, they are only taxed on the remaining $47000." For employees who are able to contribute the maximum amount allowed (See question 13) the tax savings are more noticeable. For the average person, this represents a significant saving and benefits achieving two important financial goals - not only are you saving for retirement, you are taxed less while doing so. The tax savings are of course, most noticeable at the beginning of every year - when you file your taxes.

Explains Dlouhy "Even without your company matching your contributions, the tax savings alone make the 401k an excellent opportunity". (See question 8) And because your investments are earning interest and are growing tax free, the interest you have earned stays in the 401k, allowing your account to earn even more interest, the power of compounding interest. Investment analyst Paul Dlouhy and others refer to this as "triple compounding of interest" - another huge benefit of the 401k plan.

Taxes are paid on the money in your 401k as it is withdrawn, either before or after retirement. If you withdraw from your 401k before retirement, which is something you should not do unless absolutely necessary, you will be penalized for doing so. (See question 15) The employee is taxed at the "ordinary income" rate; falling into whatever tax bracket they happen to be in at the time, even if they have retired.

If you do change jobs, as long as you rollover your 401k into your new employers plan or an IRA, you won't have to pay any taxes on that money, as technically it is never in your possession. This process is known as a "trustee to trustee transfer" and is important to know about if you stop working or change employers (See question 7). If you are no longer working for an employer don't let them continue to "work" your retirement plan.

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