- When you put money into a 401(k) plan, the amount you set aside is deducted from your federal taxable income. Depending on your tax bracket and how much you contribute, the result can be a significant tax savings year after year. For instance, if you earn $60,000 a year and contribute 10 percent of your pay to your company's 401(k) plan, your federal taxable wages drop to just $54,000 a year. This lowers your current tax withholdings and your tax liability as well.
- While putting money into a 401(k) plan lowers your federal income taxes, it has no impact on other taxes, including your Social Security withholdings. As of 2011, Social Security taxes amount to 4.2 percent of your income, regardless of whether you put money into your 401(k) plan. That 4.2 percent is slated to increase to 6.2 percent in 2012; but again, your 401(k) contribution has no impact on the amount withheld for Social Security tax.
- You can see the difference your 401(k) contributions make when you receive your W-2 form each year. Just take a look at your federal taxable wages and compare them to your state taxable wages, local taxable wages and Social Security taxable wages. You should see that your federal taxable wages are lower than those other wages by the exact amount of your 401(k) contribution. For instance, if you earn $40,000 a year and contribute $10,000 to your 401(k), your federal taxable wages will show $30,000, while your other wage categories remain at $40,000.
- It makes sense to do some advance tax planning, especially when allocating limited resources between competing retirement plans. For instance, you may find that it makes sense to limit your 401(k) contributions to the amount matched by the company, then focus your money toward deductible and Roth IRA accounts. Or, you may find that a 401(k) gives you the biggest benefits. The key is to analyze your own situation and determine the right mix of retirement plan savings for you.
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