Can I Reduce My Taxable Income with 401(K) Contributions?
If your employer offers a 401(k) plan, you may want to take advantage of the tax benefit these plans offer.
According to the IRS, "A 401(k) is a feature of a qualified profit-sharing plan that allows employees to contribute a portion of their wages to individual accounts." In layman's terms, it's a type of investment account that is used for retirement. There are a couple of key components of 401(k) plans:
Elective salary deferrals are excluded from the employee’s taxable income (except for designated Roth deferrals).
Employers can contribute to employees’ accounts.
Distributions, including earnings, are includible in taxable income at retirement (except for qualified distributions of designated Roth accounts).
401(k) plans are a helpful tax planning tool and can be leveraged to reduce your taxable income. Any contribution that you make to a traditional 401(k) plan is made on a pre-tax basis thus reducing the amount of income that your federal income tax is calculated on. Keep in mind that your 401(k) contributions do not reduce taxable wages for Social Security or Medicare.
There are limits to how much you can contribute to your 401(k) plan. For employees who participate in a 401(k) plan, the annual contribution limit for 2021 is $19,500. If you are 50 years or older, you can make an additional catch up contribution with an annual limit of $6,500.
Because your 401(k) contributions are not taxed at the time they are made, the funds withdrawn from the 401(k) will be taxed at ordinary income rates at the time of distribution. This can be a useful tool to take advantage of the contributions in higher income years and then take distributions in lower income years.
Generally, distributions of elective deferrals cannot be made until one of the following occurs:
You die, become disabled, or otherwise have a severance from employment.
The plan terminates and no successor defined contribution plan is established or maintained by the employer.
You reach age 59½ or experience a financial hardship.
If you decide to withdraw funds when you're younger than 59½, you'll be required to pay an early withdrawal penalty of 10% on top of the federal income tax. On the other hand, distributions are required once you reach a certain point in time. The required beginning date is April 1 of the first year after the later of the following years:
Calendar year in which you reach age 72 (70 ½ if you reach age 70 ½ before January 1, 2020)
Calendar year in which you retire.
This post may not contain a complete analysis of the tax issues discussed herein and does not represent official conclusions or advice regarding the matter