Contributing to an employer-sponsored 401(k) retirement plan can be a great way to save money toward your long-term financial goals. You might notice when you start saving in a 401(k) or when you make changes to how much you contribute that your take-home pay won't change by the full amount that's going into your retirement plan. That's because of the interaction between contributions you make and how much money is withheld through Form W-4. Let's look more closely at how these two tax topics relate to each other and what you can do to account for both properly.
Boosting your 401(k) contribution
When you choose to participate in your 401(k) plan at work, you divert part of the money that would ordinarily go into your paycheck and instead have it put into your retirement plan account. Therefore, it's natural to expect that your take-home pay will drop by the amount you divert into the 401(k).
However, one special aspect of 401(k) contributions is that you can use pre-tax money to make them. As a result, when you make a 401(k) contribution, the taxable part of your total pay goes down. This has an impact not just on how much income goes into your paycheck but also on how much gets withheld for federal and state income taxes.
Form W-4, tax withholding, and exempt income
When you first started your job, you probably filled out IRS Form W-4. The form asks you for your filing status and then has you calculate how many exemptions you're eligible to take. Based on this information, your employer then withholds what you say is the proper amount of federal income tax from your paycheck. In general, the more withholding allowances you claim on Form W-4, the less money will be withheld for tax and the greater your take-home pay will be.
When you contribute to a 401(k), your taxable income goes down, and so the amount of tax that your employer calculates to have withheld from your paycheck also goes down. Therefore, your take-home pay will fall by a smaller amount that you have contributed to your 401(k).
For example, say you're in the 15% tax bracket and start contributing $200 per month to your 401(k). Your monthly income will fall by $200. However, your federal tax withholding will likely drop by $30, because you have $200 less in income. As a result, your take-home pay will only decline by the difference between $200 and $30, or $170.
The key to understanding the relationship between 401(k) contributions, Form W-4, and take-home pay is that because contributions to a 401(k) represent exempt income, your taxes also go down as a result of your making a contribution. In the end, therefore, the tax benefits of your contribution will show up in your take-home pay in each paycheck.
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