The contributions you make to your 401(k) plan You can reduce your tax liability at the end of the year, as well as your tax withholding each pay period. However, you don’t actually take a tax deduction on your income tax return for your 401(k) contributions. That’s because you receive the benefit of a tax deduction every time you make a contribution with pre-tax dollars.
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Contributions to your 401(k)
The 401(k) plan contributions you choose to make come directly from your salary. Because 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 showing your earnings, you’ll notice that your wages subject to federal income tax are lower because of your 401(k) contributions.
Since wages aren’t counted in your taxable income to begin with, you don’t take a deduction when you file your return. However, when you prepare your taxes, you can calculate how much your 401(k) contributions saved you on income taxes. For example, if you contribute $8,000 to your 401(k) during the year, and that amount would be taxed in the 24 percent bracket if included in taxable income, then your tax savings is $1,920.
Increase in your net salary
Your contributions to the 401(k) plan also reduce the amount of your income tax withholding. Every time you get paid, your employer withholds money for your federal income taxes based on your expected taxable income.
However, if you make contributions to the 401(k) plan, the amount of money subject to withholding will decrease because your taxable income is less than your actual wages. The result is more money in your pocket each pay period.
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The saver’s tax credit
In addition to the tax savings available for your 401(k) contributions, the IRS also offers the Savings Credit if your Adjusted Gross Income (AGI) doesn’t exceed certain maximums. This credit offers a dollar-for-dollar reduction on your income tax bill. In 2022, single taxpayers whose AGI is no more than $20,500 ($19,750 for 2021) could receive a credit of up to $1,000, and married taxpayers filing jointly with AGI of $41,000 ($39,500 for 2021) or less could receive up to $2,000.
If your AGI does not exceed the IRS income thresholds, you are at least 18 years old, you are not a full-time student, and you are not a dependent of another taxpayer, then you can reduce your tax liability with the Saver’s Credit. TurboTax also automatically awards you the Saver’s Credit if you are income-eligible for your retirement contributions.
Misconceptions about 401(k) contributions
Contributions 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 cannot claim any deductions before these taxes are assessed. For example, if your gross salary for the month is $2,500 and you contribute $400 to your 401(k) plan, there is withholding on the full $2,500 for Social Security and Medicare, although for federal income tax purposes, there is a withholding over $2,100.
As you file your 2021 taxes, remember that you can still contribute up to $6,000 ($7,000 if you’re age 50 or older) to your IRA before the tax deadline and you can get a tax deduction on your 2021 taxes. Just remember tell your retirement account manager that your contribution is for 2021 and not 2022.
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