How 401k Tax Deduction Works


A 401k is a fairly common retirement plan offered by many companies. Basically, you contribute a certain percentage of your paycheck in to a retirement account. Your company may match that contribution up to a certain percentage. The money in that account is divided among various stocks and bonds. The ratio of stocks and bonds is usually determined by how close you are to retirement. For example, if you are thirty years old most of your 401k money is likely wrapped in stocks since they have higher yields. The closer you get to retirement, the more that money shifts toward bonds, which carry less risk. 401k money remains in the account until you reach retirement age and cannot be touched save for certain financial hardships. So how does the deduction process work?

Once you are set up on your plan, you will determine a percentage of income you wish to contribute. Many companies offer matches, usually up to 3%. This deduction is known as a pre-tax deduction. This means your 401k contribution reduces your taxable income. Therefore, the government is taken less taxes out of your salary, which can help make up for the contribution right then and there. You are not paying any taxes on the 401k until it comes time to withdraw the money. This is one of the major advantages of contributing to a 401k. Not only are you saving for your retirement, you also may place yourself in a lower tax bracket.

However, it is important to note that just because the deductions are made before taxes, that doesn’t mean you will never pay taxes for it. 401k taxes are deferred until the funds are withdrawn. At that time, you will pay the necessary taxes that go with the 401k plan. Over the life of your 401k, you are gaining money through compounding interest and capital gains and deferring the taxes. That helps the funds in your 401k climb at a better rate. When you withdraw the funds, it is treated as ordinary income and taxed as such by the federal government.

Another option available is called a Roth 401k. With a Roth 401k, contributions are made after taxes. The benefit here is that when it comes time to withdraw the funds, you will not have to pay taxes again. There are certain rules that come with a Roth 401k. For example, there are specified time frames with regards to distributions and contributions. Also, your regular taxable income is not deducted, meaning you are paying the same amount of taxes as you would if you had no 401k plan at all. So while you are avoiding the taxes come distribution time, you are paying taxes on the Roth 401k as well as paying more taxes on your regular income. Not all companies offer the Roth 401k option.

With a 401k, funds cannot be withdrawn before the retirement date. There are two exceptions to this. A hardship withdrawal can be done in instances where you need money to buy a new home, to further education, to cover medical bills, or to prevent eviction. A hardship withdrawal usually comes with a penalty and you are expected to pay taxes on it. Another option is a 401k loan. Some plans allow you to borrow up to half of your balance. You must pay it back with interest but you are only paying yourself back. With a 401k loan, you do not need to worry about taxes. However, if you lose your job before you pay back the loan it will be counted as income and you will pay taxes on it.

This post was written by

jason – who has written posts on Budget Clowns.
Father of three and married to a lovely women. Always looking for ways to save money, and invest it properly for my children's future.

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