The contributions you make to your 401(k) plan 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) plan contributions. This is because you receive the benefit of a tax deduction every time you make a contribution with pre-tax dollars.
Contributions to Your 401(k)
The 401(k) plan contributions you elect to make come directly out of your salary. Since the 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 that shows your earnings, you will notice that your wages subject to federal income tax are lower because of your 401(k) plan contributions.
Since the wages are not counted in your taxable income to begin with, you do not take a deduction when you file your return. However, when you prepare your tax return, it’s possible to calculate how much income tax your 401(k) contributions saved you. 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 it were included in taxable income, then your tax savings is $1,920.
Increase in Your Take-Home Pay
Your 401(k) plan contributions also reduce the amount of your income tax withholding. Each time you get paid, your employer withholds money for your federal income taxes based on your expected taxable income.
However, if you make 401(k) plan contributions, the amount of money subject to withholding will decrease since your taxable income is less than your actual salary. The result is more money in your pocket each pay period.
The Saver's Tax Credit
In addition to the tax savings available for your contributions to a 401(k), the IRS also offers the Saver’s Credit if your Adjusted Gross Income (AGI) doesn’t exceed certain maximums. This credit offers a dollar-for-dollar reduction of your income tax bill. In 2018, single taxpayers whose AGI did not exceed $19,250 could receive a credit up to $1,000, and married taxpayers filing jointly with an AGI of $38,500 or less could receive up to $2,000.
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