Got a 401(k)? Pay Taxes? Read This.


You’re probably tired of hearing that you should max out your 401(k), but here at the Daily Deduction, we feel compelled to say it again. A 401(k) is a great way to save for retirement, so if your employer offers one, you should make the most of it. Contributions to a traditional 401(k) aren’t included in your income, which means that you won’t be taxed on them until you retire. As a result, you might end up in a lower tax bracket this year than the one you’re used to. And there are additional, non-tax perks as well. Most employers offer automatic payroll deductions and allow you to choose your own investments. Even better, some employers offer matching contributions.

How does it work? A 401(k) allows you to defer a portion of your wages, tax free, until your retirement. The maximum wage contribution in 2009 is $16,500 for people who are fifty or younger, and $22,500 for people over fifty. When you elect to participate, your employer will take the amount of your choosing, up to the maximum, out of your paycheck and deposit it into your account. While they’re in your account, your wages will grow, tax free, in the investments of your choice. So, to recap, neither your contributions nor your investment earnings are taxed until you withdraw them, and you can start this year by contributing up to $16,500. Of course, when you retire, distributions from your 401(k) will be taxed, but probably at a lower rate than you’re paying now since you’ll no longer be earning a full paycheck.

But what if you don’t think that you’ll be in a lower tax bracket when you retire? If you plan on retiring wealthy, or if you think that the government will raise tax rates through the roof, you might want to consider a Roth 401(k). Like a Roth IRA, contributions to a Roth 401(k) are taxable instead of deductible. Investment earnings inside of the account still grow tax free. And because you pay taxes on your wages as they go in, you won’t be taxed on your retirement distributions as they come out. Last, but not least, if you think that a Roth 401(k) suits you better than a traditional account, you have to act fast. Because it was part of a Bush tax-cut package that expires next year, you won’t be able to open a Roth 401(k) after 2010 unless Congress renews the law.

You can receive retirement distributions from either a traditional or a Roth 401(k) as soon as you retire or reach the age of 59, whichever happens later. Or, if you prefer, you can delay your distributions until you reach the age of 70½. Of course, like all tax-advantaged retirement accounts, 401(k)s have penalties for early withdrawals. If you take the money and run before you retire, you’ll be taxed on the full amount of your withdrawal and you’ll have to pay a 10% penalty. Finally, if you meet certain income limitations, you can make contributions to both a 401(k) and an IRA in the same year.

Planning for retirement can be difficult, but it couldn’t be more important. 401(k) plans are a great way to save some money at tax time and a great way to prepare for the future. If your employer offers a 401(k) and you haven’t signed up yet, do it now. You’ll be glad that you did.

Don’t forget to check out our complete archive of Daily Deductions.

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