Contributions to qualified retirement plans such as traditional 401(k) plans are made on a pre-tax basis, which removes them from your taxable income and thus reduces the taxes you’ll pay for the year.
There are limits to how much you can contribute tax-free to such a plan. For 2020 and 2021, the annual limit is $19,500, and in 2022 the amount goes up to $20,500. Those age 50 or older can make an additional catch-up contribution each year of $6,500.
You can even contribute the catch-up when you are 49, provided you will turn 50 before the end of the calendar year.
- Contributions to traditional 401(k)s or other qualified retirement plans are made with pre-tax dollars, and so are deductible from your taxable income.
- You can contribute up to $19,500 a year to such a plan in 2020 and 2021, and $20,500 in 2022.
- Most plans allow an additional $6,500 annual catch-up contribution for those who will be age 50 or over by the end of the year in which the contribution is made.
- Tax brackets are often lower in retirement for many workers.
- You must pay income tax on funds you eventually withdraw from the plan, but your tax rate is typically lower in retirement than it is during your working years.
How 401(k) Contributions Cut Your Taxes
Because plan contributions shrink your taxable income, your taxes for the year should be reduced by the contributed amount multiplied by your marginal tax rate, as per your tax bracket.
The higher your income, and thus your tax bracket, the more significant the tax savings from contributing to a plan. Take, for example, a single earner who makes $208,000 a year and also contributes $5,000 annually to a plan. Their income places them in the 32% tax bracket for 2022.
Their tax savings from the contribution is, therefore, $5,000 multiplied by 32%, or $1,600.
Note, however, that if you choose the Roth 401(k) option, if your employer offers it, your contributions do not reduce your taxable income. Instead, your contributions are made with post-tax income. However, at retirement when you withdraw your contributions, you will not owe taxes on these distributions.
Many workers will find they pay less in taxes on their retirement funds when it comes time to withdraw them because often your working years are your highest earning years.
Distributions From a 401(k)
Of course, you don’t escape paying taxes forever on your 401(k) contributions, only until you withdraw them from the plan. When you do so, you must pay income tax on the withdrawals, or “distributions,” at your applicable tax rate at that time. If you withdraw funds when you’re younger than 59½, you’ll likely pay an early withdrawal penalty of 10% of the amount as well.
However, chances are you’ll pay less to withdraw funds from the plan in retirement than you did when you made the contributions. That’s because your income (and tax rate) are likely to have dropped by then, compared with your working years.
For example, let’s say our high earner retires and begins to withdraw $5,000 a year from their plan to supplement the $75,000 they receive annually from Social Security and other retirement income sources. With an income of $80,000 a year, they’d be in the 22% tax bracket and would pay $1,100 on those plan withdrawals.
Contributions and Earnings
Qualified retirement plans require this tax treatment not only of withdrawals but from the original contributions to the account. Any investment income the contributions may have earned in the years between the contribution and its distribution can also be withdrawn, with the same applicable income tax.
By doing so, it can help make maximizing your contributions to a retirement account a better investment strategy than directing money to a regular brokerage account. Why? Because skipping paying tax on your account contributions allows you to have more capital working on your behalf during the years leading up to retirement.
As an example, a person in the 22% tax bracket with 20 years until they retire might either contribute a pre-tax $400 a month to a 401(k) plan or divert the same amount of earnings to a brokerage account. The latter option would yield only a monthly contribution of $312 after paying a 22% tax on the $400 in income.
The extra $102 per month from the 401(k) option not only increases contributions but further expands the nest egg by having a larger balance on which earnings can compound over decades. The difference between the scenarios could amount to tens of thousands over the long run.