Income Taxes and Your 401(k)

Save on Your Income Taxes With Your 401(k)

If you’re interested in saving on your income taxes, there are few ways to do it that are as potentially profitable as making use of a 401(k) account through your employer.  While the 401(k) shouldn’t be the only component of a potential retirement plan, it is an important one, particularly in that it comes with built-in tax savings.  The money invested in a 401(k) is pre-tax savings, which effectively reduces your taxable income, resulting in paying lower taxes.

What makes the 401(k) an even better way to save money on taxes and save money for retirement is the fact that many employers are willing to match an employee’s 401(k) contribution up to a certain level.  We once had a job where the employer was willing to match our contributions up to 5% of our salary.  By putting 5% of our salary into our 401(k), we were able to effectively obtain a 5% raise.

Surprisingly few people make the maximum contributions to their 401(k) each year.  Some 40% of workers in their twenties and 30% of workers in their thirties fail to contribute to their 401(k) accounts at a sufficient level to qualify for the company match.  By failing to do so, they are not only paying more in income taxes than they otherwise might, but they are also doing substantial damage to their potential retirement savings.

bannerOne of the benefits of putting money into a 401(k) at an early age is the power of compounding interest.  The money you put into your 401(k) today at, say, the age of 21, will have more than 40 years to earn interest.  Someone who doesn’t start saving until they are 40 will earn substantially less over the length of their career.  It’s actually possible to put money in your 401(k) at the age of 21, continue until you’re 30, stop there, and still retire as a millionaire.  If you keep contributing, you’ll earn even more at retirement, possibly becoming a multimillionaire.  Of course, the money you withdraw at retirement is taxable, but in the meantime, you’ve earned enough money to pay those taxes while enjoying the tax breaks of having a 401(k) the entire time.

There are some ramifications to taking advantage of your employer’s 401(k) match, however.  Most employers have a requirement that you stay with the company for a certain length of time before the company’s contribution will vest.  If you leave the company before their contributions vest, they’ll simply take them back when you leave.  Since you’re potentially leaving a lot of money on the table by changing jobs before your employer’s contributions fully vest, it pays to take this into consideration if you’re thinking about changing jobs.  It could potentially cost you thousands of dollars at retirement.

retirement savingsIf you haven’t been making regular contributions to your 401(k) or you’ve been contributing but haven’t been making the maximum contribution and are therefore losing out on the company match, now might be a good time to fix that.  If you’ve just received a sizable tax refund, you might be able to apply some of that to your 401(k) in order to meet your employer’s match.   Alternatively, you could put that money into a Roth IRA, which is an investment tool that allows you to put post-tax income into a retirement account now, with the money you withdraw at retirement being tax free.

There are lots of ways to save money on your income taxes and lots of ways to take legal income tax deductions that can reduce your taxable income.  All of these are nice and they can add up to some fairly substantial savings.  The 401(k) is special, however, because the contributions you make to your 401(k) are not only based on pretax income, but they also go into a fund that will pay you money later.  Other tax-reducing expenses, such as mortgage interest, don’t do that.

If you’re not making the maximum contribution to your 401(k), you’ll likely have some decisions to make.  Most working adults, particularly young ones, have a number of expenses that can get in the way of making retirement contributions.   Having a young family, or a recently purchased home or a new car are all things that can add up to consume a substantial portion of an employee’s salary, and it can be difficult to try to decide how to allocate funds when it comes to deciding between paying down debt and putting funds away for retirement.  How you allocate those limited funds is up to you, but if you’re already contributing to your 401(k) but you aren’t doing so at a sufficient level to qualify for your employer’s match, then you’re effectively taking a lower salary than you’re entitled to.  It would make sense in that situation to try to find the additional funds so that you can qualify for your employer’s match, even if it means cutting back on something else.

Retirement is expensive, and most Americans fail to save enough to allow themselves to have a reasonable lifestyle after retirement.  Many are surprised at just how much they have to cut back once they stop receiving a paycheck.  Individual Retirement Accounts and 401(k) accounts make it possible to put enough money away for a good retirement while you’re still young and allow you to save on your income taxes in the meantime.  These are powerful tools, but they can’t help you unless you take advantage of them while you’re young and working and in a position to let compound interest do its work over a period of decades.

Tax deductions are great, and we spend a lot of time writing about those.  We encourage everyone to find out about all of the deductions that they can legally take in order to reduce their taxes.  But deductions only lower your tax bill.  A 401(k) can do that and help you become a millionaire at retirement.  That’s an opportunity that no one should pass up.  It’s easy to do; all you have to do is get started now.

Want to learn more about saving on your income taxes?  Click here to see how to save.

 

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