Most people need to save independently to ensure they have enough money once they retire. If your company offers a 401(k), participating in that plan could help you save money for the future. But there's even better news: Your 401(k) can also help you save money on taxes. The withdrawals you take from a 401(k) in retirement are taxed at your ordinary income rate -- unless, of course, you take an early distribution, in which case you'll incur an additional penalty. However, the money you contribute goes in tax-free, which can lower your taxes during your working years.
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Tax benefits when you need them the most
The beauty of the 401(k) is that it allows to lower your tax bill at a time when you're earning a steady income and your tax rate is likely to be highest. When you contribute to a 401(k), the money goes in on a pre-tax basis. Currently, anyone under 50 can contribute up to $18,000 a year to a 401(k). If you're 50 or older, you're allowed a $6,000 catch-up contribution for an annual total of $24,000.
Let's say you're 52 years old and your effective tax rate is 28%. If you manage to max out your annual 401(k) contribution at $24,000, you'll save about $6,700 in taxes the year you make that contribution. Now, keep in mind that you will pay taxes on that money eventually -- just not right away. But if your effective tax rate in retirement is lower than 28%, and when you take withdrawals then (like you're supposed to), you'll come out ahead by paying less tax on that contribution overall.
Furthermore, if you think you can't afford to contribute to a 401(k), consider the fact that doing so will lower your taxes today, thus freeing up at least some money for you to set aside for retirement. Let's say you want to contribute $2,000 a year but don't do it because you don't want to part with that much money. If your effective tax rate is 25%, then in reality, you're not parting with $2,000 -- you're only parting with $1,500.
Of course, you're not actually parting with that money at all, because it'll be available for you in retirement when you need it. But if you're not thrilled with the idea of having less disposable income at present, remember that you're not losing as much from each paycheck as you'd think.
Paying taxes on 401(k) withdrawals
While a 401(k) can help lower your taxes the years you contribute, it unfortunately won't provide tax relief in retirement. In fact, distributions in retirement are taxed as ordinary income -- something many retirees aren't prepared for.
Furthermore, if you take money out of your 401(k) before you reach age 59 1/2, your distributions will be taxed as ordinary income and you'll be hit with a 10% early withdrawal penalty -- unless you happen to qualify for an exception. You can, for example, withdraw funds penalty-free before 59 1/2 if you need the money to pay for medical expenses that exceed 10% of your adjusted gross income for the year. Similarly, if you separate from the company sponsoring your 401(k) during the year you turn 55 or later, you can take that money with you and avoid a penalty. Generally speaking, though, early withdrawals are taxed and penalized.
While withdrawing funds early from a 401(k) is a bad move, waiting too long can be even more problematic. If you have a 401(k), you're actually required to start taking withdrawals once you reach age 70 1/2. Fail to abide by that rule, and you could face a 50% penalty on the amount you should've withdrawn but didn't. Of course, the kicker is that although you have no choice but to withdraw that money, you'll still need to pay taxes on your distributions. Go figure.
While the money you have in your 401(k) will be taxed eventually, you'll get a huge up-front tax break by contributing during your working years. And the sooner you begin putting money into that account, the greater your chances of saving enough for a financially secure retirement.
