Contributions you make to your 401(k) plan can reduce your tax liability at the end of the year as well as your tax withholding each pay period. However, you do not actually take a tax deduction on your income tax return for your 401(k) plan contributions. This is because you receive the benefit of a tax deduction every time you make a contribution with pre-tax dollars.
Contributions to Your 401(k)
The 401(k) plan contributions you elect to make come directly out of your salary. Since the contributions are made with pre-tax dollars, your employer does not include these amounts in your taxable income for the year. At the end of the year, when you receive your W-2 form that shows your earnings, you will notice that your wages subject to federal income tax are lower because of your 401(k) plan contributions. Since the wages are not counted in your taxable income to begin with, you do not take a deduction when you file your return. However, when you prepare your tax return, it’s possible to calculate how much income tax your 401(k) contributions saved you. For example, if you contribute $8,100 to your 401(k) during the year and that amount would be taxed in the 33 percent bracket if included in taxable income, then your tax savings is $2,673.
Increase in Your Take-Home Pay
Your 401(k) plan contributions also reduce the amount of your income tax withholding. Each time you get paid, your employer withholds money for your federal income taxes based on your expected taxable income. However, if you make 401(k) plan contributions, the amount of money subject to withholding will decrease since your taxable income is less than your actual salary. The result is more money in your take-home pay each pay period.
The Savers Tax Credit
In addition to the tax savings available for your contributions to a 401(k), the IRS also offers the Savers Credit if your Adjusted Gross Income (AGI) doesn’t exceed certain maximums. This credit offers a dollar-for-dollar reduction of your federal income tax bill. In 2010, single taxpayers whose AGI doesn’t exceed $27,750 can receive a credit up to $1,000 and married taxpayers with an AGI of $55,500 or less can receive up to $2,000. If your AGI doesn’t exceed these thresholds, you are at least 18 years of age and are not a dependent to another taxpayer, then you need to prepare IRS Form 8880 with your tax return to claim the tax credit.
Misconceptions About 401(k) Contributions
The contributions that you make to a 401(k) plan only reduce your income taxes, not your Social Security and Medicare taxes. These two taxes only apply to your earned income, but you do not get to claim any deductions before these taxes are assessed. For example, if your gross wages for the month are $2,500 and you contribute $400 to your 401(k) plan from it, there is withholding on the full $2,500 for Social Security and Medicare even though for federal income tax purposes, there is withholding on $2,100.