It's no secret that 401(k) plans often offer a number of advantages, from employer matching contributions to professional investment advice. And while you may think of your 401(k) only in the context of retirement, the truth is that it can offer a number of advantages right now - and throughout your career. Many of these could be related to your taxes, which are certainly top-of-mind for most of us as the April filing deadline approaches. By taking stock of the possible tax benefits inherent in your 401(k), you may be able to lower your tax burden for this year and beyond.
1. Contributing to a traditional 401(k) might put you in a lower tax bracket.
When traditional 401(k) pre-tax contributions are deducted from your paycheck before federal income taxes are withheld, this effectively lowers your taxable income. Depending on your tax income bracket, if you make a significant contribution, you might put yourself into a lower tax bracket altogether, allowing you to keep even more of your pay while you defer taxes on your 401(k) contributions.
2. Choosing a Roth 401(k) could reduce your tax burden in the long run.
A Roth 401(k) contribution offers a different strategic tax planning opportunity than a traditional pre-tax 401(k) contribution. Roth 401(k) contributions are made on an after-tax basis, and distributions from your account are tax-free*, including any investment earnings, after you meet certain requirements. This can be a solid option for young workers currently in a lower tax bracket, and anyone else who expects to retire in a higher tax bracket.
Roth 401(k) contributions have become increasingly popular in recent years. At Schwab Retirement Plan Services, nearly three-quarters of the plans we service as a record keeper offer a Roth 401(k) option, up from about 60 percent just five years ago. More than 20 percent of participants in those plans with access to Roth 401(k) contributions are utilizing them, so it might be time to evaluate whether it makes sense for you, too. You also may be able to split your contributions between traditional pre-tax and Roth 401(k) as another tax planning option. If advice is offered as part of your plan, ask a financial professional what makes sense in your situation.
3. You could be eligible for a 401(k)-related tax credit.
Depending on your income and filing status, you may be able to lower your tax bill even further by taking advantage of the Retirement Savings Contributions Credit, also known as the Saver's Credit. Introduced by the IRS in 2002, its purpose is to give low- and moderate-income workers a special credit for saving for retirement. According to the IRS, those who meet eligibility requirements can take a credit of up to $2,000 (or $4,000 if you're married and filing jointly), so it's worth finding out if you meet the criteria.
4. Dipping into your 401(k) can hurt you from a tax perspective.
While withdrawing money from your 401(k) might seem like a solution when you face an emergency, doing so can come with hefty tax penalties. In fact, if you withdraw money from your plan before age 59½, you'll likely face a 10 percent federal penalty. In addition, the government will take 20 percent of your withdrawal as an advance on your tax bill. The same goes if you cash out your 401(k) when you leave your job. It's also important to note that some plans may bar employees who have taken a withdrawal from contributing for the next six months, which will only further derail your savings efforts.
5. A 401(k) loan can also have tax consequences.
One thing I always tell participants is that a 401(k) loan should be viewed only as a last resort. There are a number of negative consequences associated with taking 401(k) loans, especially where taxes are concerned. First of all, you must repay the loan with after-tax dollars, negating many of the great tax benefits of the plan. Moreover, if you leave your job before you pay back the loan in full, your outstanding balance is treated as a withdrawal, spurring a tax bill and potentially an additional 10 percent penalty.
By understanding the important role your 401(k) plays in your overall financial picture, you can face Uncle Sam knowing that one of your most fundamental savings tools is working to help you manage your tax burden.
* Your contributions and any earnings may grow without additional taxes applied at distribution if certain conditions are met, and you will not pay taxes on the money when it is withdrawn, provided that any distribution from your plan account occurs at least five years following the year you make your first Roth 401(k) contribution, and you have reached age 59½ or have become disabled.
This information is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, you should consult with a qualified tax advisor, CPA, Financial Planner or Investment Manager.
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