401(k) Tax Deductions

401k nest egg

A 401(k) is a retirement savings device in which an employee elects to have a portion of his or her earnings placed into a savings account. Contributions, which the Internal Revenue Service (IRS) refers to as "elective contributions," are subtracted from the employee's income before taxes. Contributions are not taxed until withdrawn.

Understand Your 401(k)

Before understanding the tax advice and planning options available, you must first understand the workings of a 401(k). In a 401(k) agreement, an employee elects to have a portion of their pre-tax income contributed to a savings account. Contributions are invested and, as such, earn income.

The exact rules regarding how much an employee can contribute, whether their employer will match contributions and how contributions are invested are up to the employer. Self-employed individuals can also establish a 401(k). Contributions are limited; in 2012, a taxpayer could only contribute a maximum of $17,000 per year. However, in 2013, contributions limits increased to $17,500 per year.

Deposited funds are not taxed because they are subtracted from the employee's paycheck before the income is taxed. Instead, contributions are taxed when they are distributed to the employee. The IRS does not allow withdrawals prior to age 59 and one-half without a penalty, except in instances of extreme distress. The general penalty is that distributions are subjected to an additional 10 percent tax.

Tax Deductions for Contributors

Because elective contributions are not considered part of the employee's income and are not taxed, they lower the amount of the employee's taxable income. Possibly, these contributions could result in the employee being in a lower tax bracket.

However, contributions are not deductible. This is because they are made before taxes. This means that they are technically not income because they were never received by the employee. Any employer-matched contributions are likewise not deductible for this same reason. The tax benefits of a 401(k) stem from the fact that contributions to it:

  • Come out before taxes, thereby possibly lowering the tax bracket
  • Grow from being invested tax-free.

The only tax benefit available to 401(k) contributors is the "Savers Credit," formerly known as the "Retirement Savings Contribution Credit." This program - note that it is not a deduction - provides low to moderate-income taxpayers who contributed to a 401(k) with a credit of as much as $1,000 for single taxpayer and $2,000 for married taxpayers. The amount of credit is determined by the taxpayer's adjusted gross income and the amount they contributed.

Single, Married Filing Separately, or Qualifying Widower Taxpayer Status (2012)

  • Income up to $17,250 = 50% credit
  • $17,251-$18,750 = 20% credit
  • $18,751-$28,750 = 10% credit

Married Taxpayers Filing Jointly (2012)

  • Income up to $34,500 = 50% credit
  • $34,501-$37,500 = 20% credit
  • $37,501-$57,500 = 10% credit

Taxpayers with incomes higher than that permitted for the 10 percent credit are ineligible to claim the credit; for 2013, the top income level for this credit for single taxpayers increases to $29,500 and to $59,000 for married taxpayers filling jointly. The credit can be claimed on Form 8880, titled "Credit For Qualified Retirement Savings Contributions."

Tax Benefits for Distribution Recipients

Retired individuals receiving distributions from a 401(k) plan must pay taxes on the amounts they receive. Exceptions to this rule exist when:

  • The distribution was court ordered, such as in a divorce action
  • When the participant in the plan dies
  • When the participant becomes disabled and requires the funds to live from

Some retirees, however, may be eligible to transfer their traditional 401(k) into a Roth 401(k). A Roth 401(k) operates the same way as a traditional 401(k), except that deposited funds are taxed prior to being added to the account. Because they are taxed at the outset, they are not taxed subsequently, when distributed.

This type of conversion is only eligible to individuals participating in a plan that offers a Roth 401(k) option, meaning that their employee offers the type of account. Additionally, only those monies to which they are entitled to have distributed to them are transferable. Therefore, the employee must be older than 59 and one-half. IRS Notice 2010-84 explains the specifics of this option.

Planning with your 401(k)

Despite offering little in the way of tax deductions, 401(k)s are essential retirement accounts for every taxpayer. Financial expert Dave Ramsey recommends that all individuals, including those just beginning to save for retirement, establish a 401(k).

Bloomberg.com provides taxpayers with a 401(k) calculator to see just how far their accounts will take them. Orman also encourages all taxpayers to maximize their 401(k) contributions, particularly if your employer matches your contributions.

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401(k) Tax Deductions