When planning for retirement, investors might hear about a “401(k) tax deduction.” But while there are tax benefits associated with contributing to a 401(k) account, there is no such thing as a 401(k) tax deduction.
A deduction reduces the amount of someone’s income that is subject to tax which can lead to lowering the amount of taxes they have to pay. An individual cannot deduct their 401(k) contributions on their income tax return to lower their taxable income.
However, 401(k) contributions typically come directly out of the participant’s salary with pre-tax dollars—which can reduce tax liability and the tax withholding that occurs during each pay period. Any money contributed to a 401(k) is not included in the employee’s taxable income for that year. As a result, participants can pay less in taxes as they are being taxed on only a portion of their income.
How Do 401(k) Contributions Affect Your Taxable Income?
The benefits of putting pre-tax dollars toward one’s 401(k) plan are similar to a tax deduction, but are technically different. For elective deferrals and investment gains, that income is not taxed and experiences a tax deferral until the distribution of the funds.
For employers contributing to employee 401(k) plans, their contributions are deductible on their federal income tax return, as long as their contributions don’t surpass the limitations outlined in section 404 of the Internal Revenue Code.
In the Internal Revenue Code section 404, it outlines that an employers’ contribution has a deduction limit of 25 percent of the eligible employee’s compensation.
Do You Need to Report 401(k) Contributions on Your Tax Return?
When an individual receives a contribution to their 401(k) from an employer, that contribution is categorized as a deferred compensation plan. Because a 401(k) plan is a deferred compensation plan, typically the income received (known as elective contributions) is not subject to income tax withholding during deferral.
This means that the participants do not have to report this income as wages on their Form 1040, U.S. Individual Income Tax Return or Form 1040-SR, U.S. Tax Return for Seniors. However, that income is included as wages that are subject to withholding for Social Security and Medicare taxes. Those wages are then subject to federal unemployment taxes.
In short, because 401(k) contributions are made before being taxed, they are not included in taxable income and they do not need to be reported on a tax return. The exception being, when a participant takes a distribution from their 401(k) account—typically after retiring—that is when they’ll be required to report the income on their tax return, and pay the correct amount of taxes.
When you’re retired and withdrawing, the hope is that you’re in a lower tax bracket than when you were working. In turn, the amount you’re taxed will be relatively low.
How Do 401(k) Withdrawals Affect Taxes?
The tax rules for withdrawing funds from a 401(k) account differ depending on when a plan participant withdraws the money.
Generally, all traditional 401(k) retirement plan distributions are eligible for income tax upon withdrawal of the funds (note: that rule does not apply to Roth 401(k)s, since contributions to those plans are made with after-tax dollars).
Withdrawals that occur before the age of 59½ are known as “early” or “premature” distributions. For these early withdrawals, individuals have to pay an additional 10% tax as a part of an early withdrawal penalty, with the following exceptions (as described by the IRS):
• Permissive withdrawals from plans that have auto enrollment features
• Timely corrective distributions and any associated earnings of excess contributions, excess aggregate contributions, and excess deferrals
• After the death of the plan participant
• After the total and permanent disability of the plan participant
• When distributed to an alternate payee under a Qualified Domestic Relations Order
• During a series of substantially equal payments
• When the dividends pass through from an ESOP (employee stock ownership plan)
• Due to an IRS levy of the plan
• If the amount of unreimbursed medical expenses meets specified requirements
• Certain distributions for qualified military reservists called to active duty
• Eligible distributions contributed to another retirement plan or an IRA within 60 days
• If the employee separates from service during or after the year they reach age 55 or age 50 if the participant is a public safety employees of a state, or political subdivision of a state, in a governmental defined benefit plan
For individuals looking to withdraw from their 401(k) plan before age 59½, a 401(k) loan may be a better option that will not result in withdrawal penalties.
How do Distributions From a 401(k) Work?
While there is some flexibility on when a participant can pull their funds out once they reach retirement age, they cannot keep their retirement funds in their account for as long as they wish. Generally, participants must pull the money out by the time they reach age 70½, but for those whose 70th birthday is on July 1st, 2019 or later, they don’t have to take withdrawals until they turn 72.
Participants don’t have to withdraw all of their retirement savings at once, but they do have to comply with an annual required minimum distribution (RMD). The IRS has a worksheet for individuals to figure out their RMD, including a chart that maps distribution over projected life expectancy, based on current age.
Traditional 401(k) distributions, including earnings, are considered a part of taxable income at retirement.
What are Tax Saver’s Credits?
Making eligible contributions to an employer-sponsored retirement plan such as a 401(k) or an IRA can potentially lead to a tax credit known as a Retirement Savings Contributions Credit, or a Saver’s Credit . There are certain eligible requirements that must be met to qualify for this credit.
1. Individual must be age 18 or older
2. They can not be claimed as a dependent on someone else’s return
3. They can not be a student (certain exclusions apply )
The amount of the credit received depends on the individual’s adjusted gross income reported on their Form 1040 series return. The credit amount is typically 50%, 20% or 10% of:
• Elective salary deferral contributions made to a 401(k), 403(b), governmental 457(b), SARSEP, or SIMPLE plan
• Contributions made to a traditional or Roth IRA
• Voluntary after-tax employee contributions made to a qualified retirement plan or 403(b) plan, contributions to a 501(c)(18)(D) plan, or contributions made to an ABLE account for which you are the designated beneficiary
For 2020 the maximum contribution amount that qualifies for this credit is $2,000 for individuals and $4,000 for married couples filing jointly, bringing the maximum credit to $1,000 for individuals and $2,000 for those filing jointly. Rollover contributions don’t qualify for this credit.
Alternatives for Reducing Taxable Income
Aside from contributing to a traditional 401(k) account, there are other ways to reduce taxable income while putting money away for the future.
• Traditional IRA: Traditional IRAs are one type of retirement plan that can lower taxable income. Individuals may be able to deduct their traditional IRA contributions on their individual federal income tax returns. The deduction is typically available in full if an individual (and their spouse, if married) doesn’t have retirement plan coverage offered by their work. Their deduction may be limited if they or their spouse are offered a retirement plan at work and their income exceeds certain levels.
• SEP IRA: SEP IRAs are a possible alternative investment account for individuals who are self-employed and don’t have access to an employee sponsored 401(k). Taxpayers who are self-employed and contribute to an SEP IRA can qualify for tax deductions.
• 403(b) Plans: A 403(b) plan is a retirement plan that select employees may qualify for, such as employees of public schools and tax-exempt organizations, and certain ministers. Employees with 403(b) plans can contribute some of their salary to the plan, as can their employer. As with a traditional 401(k) plan, the participant doesn’t need to pay income tax on any allowable contributions, earnings, or gains until they begin to withdraw from the plan.
• Charitable donations: It’s possible to claim a deduction on federal taxes after donating to charities and non-profit organizations with 501(c)3 status. To deduct charitable donations, an individual has to file a Schedule A with their tax form and provide proper documentation regarding cash or vehicle donations. To deduct non-cash donations, they have to complete a Form 8283. For donated non-cash items, individuals can claim the fair market value of the items on their taxes. This guide from the IRS explains how to determine vehicle deductions. For donations that involve receiving a gift or a ticket to an event, the donor can only deduct the amount of the donation that exceeds the worth of the gift or ticket received. Individuals are generally required to include receipts when they submit their return.
• Earned Income Tax Credit: Individuals and married couples with low to moderate incomes may qualify for the Earned Income Tax Credit (EITC). This particular tax credit can help lower the amount of taxes owed if the individual meets certain requirements and files a tax return—whether or not the individual owes money. Filing a return in this case can be beneficial, because if EITC reduces the amount of taxes owed to less than $0, then the filer may actually get a refund.
Individuals who expect a 401(k) deduction come tax time may be disappointed to learn that there is no such thing as a 401(k) tax deduction. But they may be pleased to learn the other tax benefits of contributing to a 401(k) retirement account.
Contributions are made with pre-tax dollars, which effectively lowers one’s amount of taxable income for the year—and that may in turn lower the amount of income taxes owed.
Once an individual reaches retirement age and starts withdrawing funds from their 401(k) account, that money will be considered income, and will be taxed accordingly.
For individuals looking for alternative ways to reduce taxable income, there are other options, including contributing to traditional IRAs, SEP IRAs, 403(b) plans, and making charitable contributions to organizations with 501(c)3 status.
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