How a 401(k) Can Help You Save on Taxes

By ShareBuilder 401k

How a 401(k) Can Help You Save on Taxes

If you're looking to secure your financial future and reduce your tax burden, a 401(k) plan can be a powerful tool in your arsenal. With high contribution limits, tax credits, and tax-deductible expenses, a 401(k) plan can provide rich benefits for both the business owner and their employees. In fact, with these tax benefits and the introduction of low-cost providers, 401(k) plans are becoming much more popular for every size business, including the self-employed.

The Basics of a 401(k) Plan

Before we dive into the tax-saving aspects, let's briefly review what a 401(k) plan is. A 401(k) is a tax-advantaged retirement savings account offered by employers to their employees. It allows you to contribute a portion of your income pre-tax or after tax via the Roth 401(k) feature to your retirement fund. The funds in your 401(k) can then be invested in a variety of assets such as stocks, bonds, and cash typically with ETFs and/or mutual funds, enabling your money to grow over time.

Now, let's explore how a 401(k) can help you save on taxes:

5 ways a 401(k) can help you save on taxes:

  1. Defer up to $69,000 from 2024 Taxes: Go ahead and up that number to $76,500 if you’re at least 50 years old. As an employee of your company, you may contribute up to $23,000 to the plan from your salary ($30,500 if age 50 or more), and you can also receive any matching and/or profit-sharing contributions that you provide to the plan up to the limits. This tax savings alone may cover all of the plan costs for some small firms from a small business owners perspective.

  2. Receive up to $16,500 in tax credits: Businesses with at least one employee (in addition to the owner) and up to 100 employees, qualify for an annual tax credit of up to $5,000 to offset 100% of plan administrative costs. For those with less than 51 employees (half of the administrative costs for those with 51-100 employees) for the first three years – that’s a potential cumulative savings of $15,000 over three years. Administrative costs will vary by the number of employees that participate in your plan. For a business with 10 employees just starting their first retirement plan, expect to pay about $1,200 a year. Subtract the credit that covers 100%, and that’s a pretty low-cost plan to administer at $0 per year. In addition, if you choose the automatic enrollment feature with auto-escalation, you qualify for another $500 per year for the first three years.

  3. Hedge future taxes with a Roth 401(k): A Roth 401(k) enables small business owners and employees to make after-tax contributions with no income level restrictions – unlike the Roth IRA which has income limits. This means that employees that use the Roth 401(k) option will have the advantage of tax-free withdrawals – earnings and all – when they use these funds in retirement. Owners and employees can choose to put all, part, or none of their personal contributions into their Roth.

  4. If you choose to match, there are tax credits available and they’re tax deductible too: Employer contributions are optional in 401(k) plans. But choosing not to match can limit how much highly compensated employees (including owners) can put into their 401(k) account. The good thing is that by providing a relatively small match to eligible employees (employees earning less than $100k a year), you can maximize your own contributions. Plus, if you have less than 100 employees, you can qualify for tax credits tax credits of up to $1,000 per employee for your first 50 employees for your employer contributions. It keeps getting better. Employer contributions are often a 100% tax-deductible expense too for your business for amounts not covered by the tax credits.

  5. 401(k) profit-sharing can help manage business taxes: Profit-sharing is discretionary for your business. You can provide one in good years and cut it out in tougher times. The amount of profits you share will lower your business earnings, so there will be less for the IRS to take. That's not the only good news: the profit share will increase your 401(k) account savings, and since it’s a tax-deferred contribution, there are no personal tax consequences until withdrawals are made. You and your tax advisor can run the numbers each year and determine what amount is best for your organization.

Do You Pay Taxes on 401(k) Contributions?

One of the fundamental questions surrounding 401(k) plans is whether you pay taxes on your contributions. The answer depends on whether you opt for pre-tax or post-tax (Roth) contributions.

Pre-tax 401(k) Contributions

  1. Pre-tax contributions are made before your income is subject to taxation. This means that the amount you contribute to your 401(k) is deducted from your taxable income, reducing the income you report on your annual tax return for the current year. As a result, you pay less in income taxes in the year you make the contribution. However, it's important to note that you will pay taxes on your withdrawals during retirement.

  2. Immediate tax benefits: Reduce your taxable income in the year of contribution.

  3. Lower current tax liability: Enjoy potential tax savings in the present.

  4. Tax-deferred growth: Investment gains within the account are tax-deferred until withdrawal.

  5. Taxation in retirement: Pay taxes on withdrawals during retirement, including both contributions and investment gains.

Post-tax 401(k) Contributions (Roth 401(k))

  1. In contrast, post-tax contributions, often referred to as Roth 401(k) contributions, are made after your income has been taxed. This means you won't receive an immediate tax break in the current year when you contribute to your Roth 401(k).

  2. Tax-free withdrawals in retirement: Enjoy tax-free access to both contributions and investment gains during retirement.

  3. No immediate tax deductions: Contributions are made with after-tax dollars, providing no immediate tax break.

  4. Greater tax diversification: Combining post-tax Roth contributions with pre-tax contributions can offer tax flexibility in retirement.

  5. Ideal for long-term tax planning: Roth 401(k) contributions are well-suited for those who anticipate being in a higher tax bracket during retirement.

Is 401(k) Pre-tax or Post-tax for You?

Determining whether pre-tax or post-tax 401(k) contributions are right for you depends on your unique financial situation and long-term goals. Here are some considerations to help you decide:

  • Current tax bracket: Evaluate your current income tax bracket. Pre-tax contributions are more beneficial if you are in a higher bracket, as they provide immediate tax savings.

  • Future tax bracket: Consider your expected tax bracket during retirement. If you anticipate being in a higher tax bracket in retirement, Roth contributions may be more advantageous.

  • Tax diversification: Some individuals choose a combination of both pre-tax and post-tax contributions to create tax diversification, giving them flexibility in retirement.

  • Long-term planning: Assess your long-term financial goals and retirement plans. Your choice between pre-tax and post-tax contributions should align with your retirement strategy.

401(k) Tax Benefits

401(k) plans offer several tax benefits, making them an attractive option for retirement savings:

  • Pre-tax contributions: Reduce your current taxable income, potentially leading to lower income tax liability.

  • Tax-deferred growth: Any investment gains within your 401(k) account are not taxed until you withdraw the funds during retirement.

  • Post-tax Roth 401(k) contributions: Provide tax-free withdrawals in retirement, allowing you to access both your contributions and investment gains without paying any federal income tax.

401(k) Profit-Sharing

In addition to your own contributions, some employers offer profit-sharing contributions to employees' 401(k) accounts. Profit-sharing is an enticing incentive for employees to save for retirement, as it effectively boosts their retirement savings without requiring additional contributions from their own pockets. Again, profit-sharing technically lowers your overall business earnings, which means they are tax deductible.

Tax-Advantaged Investments

While 401(k) contributions are not entirely tax-free, they offer significant tax advantages that can help you grow your retirement savings more efficiently than taxable investment accounts. Know that dividends and capital gains aren’t taxed in your 401(k) account until withdrawn. Pre-tax contributions and earnings are only taxed on withdrawal; and Roth contributions and earnings aren’t taxed again when withdrawn in retirement. The tax-deferred growth within a 401(k) can have a substantial impact on your retirement nest egg.

Roth 401(k) vs. Traditional 401(k)

In summary, the choice between Roth 401(k) and traditional 401(k) contributions involves weighing immediate tax benefits against tax-free withdrawals in retirement. Both options have their merits and can be valuable for different individuals depending on their financial circumstances and goals.

Starting a 401(k) can help you for the 2024 tax year:

To ensure maximum tax benefits in the year ahead, it pays to get started sooner than later. Talk to your tax advisor and see how a small investment in a 401(k) can pay big dividends now as well as later when you decide it’s time to retire.

How Much Should I Contribute to My 401(k)?

Many financial advisors suggest saving 10-15%* of your income over your career for a comfortable retirement. This can be easier if your company’s 401(k) plan offers an employer match as that counts towards this savings percentage too. Plus, a 401(k) match is essentially free money.

If you start saving mid-life or later, you may need to save more than 15% of your income to try and catch-up. Regardless of where you are, you can build meaningful retirement savings by assessing where you are and knowing the products, features, and retirement contribution limits as well as understanding some key concepts such as the power of compounding.

Key Takeaways:

  • 401(k) plans offer various tax benefits through pre-tax and post-tax (Roth) contributions.

  • Pre-tax contributions reduce your current taxable income and are tax-deductible.

  • Post-tax contributions provide tax-free withdrawals in retirement, including both contributions and investment gains.

  • Some employers offer profit-sharing contributions, enhancing employees' retirement savings.

  • The decision between pre-tax and post-tax (Roth) contributions depends on your tax situation, retirement goals, and long-term financial strategy.

In conclusion, understanding the tax implications of your 401(k) contributions is essential for optimizing your retirement savings strategy. Consult with a financial advisor or tax professional to make informed decisions about your retirement planning. Your 401(k) can be a powerful tool for saving on taxes and securing a financially comfortable retirement.

*This material is intended only as general information for your convenience and should not in any way be construed as investment or tax advice by ShareBuilder 401k. The owner/participant should consult with their tax advisor regarding any specific tax strategies. *

Meet the Author

Our low-cost 401k plans are easy to setup online and are supported by our 401k advisors and specialists. ShareBuilder 401k serves small business and medium-sized companies, as well as the self-employed. We offer Roth 401k, Safe Harbor 401k, Traditional 401k, and Solo 401k options. Your 401k plan is paired with investment management expertise and employee education to help you save more.