There are a number of advantages to participating in a 401(k) plan. Your contributions are pre-tax, which gives you more money to invest. Your earnings are not taxed until withdrawal. (Earnings in the Roth 401(k) are not taxed at all.) You have the option of rolling your 401(k) into other tax-deferred employment plans if you change employers. You have access to some of the money in an emergency. Your employer may match your contribution—in effect, giving you a bonus. And the plan will let you choose from a variety of investments.
You will pay taxes on your 401(k) plan contribution and earnings when you begin to take the money out of the 401(k) plan (generally at retirement). But the remarkable advantage is that even after you have paid taxes on your 401(k) account, you still have accumulated much more money than you could with a taxable savings account.
Let's take a look at an example to show what it really costs you to make a 401(k) pretax contribution. Assume you get paid a gross monthly salary of $3,500 and your tax rate is 25%. You contribute 10% of your gross pay to the 401(k) plan. Does it really cost you $350? No, after the tax 'benefit', it only costs you $262. You'll pay taxes eventually, but when you make a 401(k) contribution, the money going into the plan is not taxed currently.
No 401(k) Contribution
Gross monthly pay
Net monthly pay
If you contribute $350 each month to a 401(k) plan, your net take home pay is $262 less than if you hadn't contributed anything. In other words, you saved $350 for retirement, but your take home pay was only reduced by $262. You saved taxes of $88, which you put into your retirement fund.
Many people struggle to carve out the funds they need to build up their retirement nest eggs. Fortunately, a non-refundable tax credit, known as the retirement savings contribution credit, can make it substantially easier to save. Often referred to as the saver's credit, it lets qualified individuals enjoy tax breaks above and beyond any tax deductions they may receive from contributions to their IRAs or employer-sponsored plans. By reducing tax liability, the credit offsets the cost of funding a retirement account, ultimately bolstering savings potential.
The saver's tax credit is a non-refundable tax credit available to eligible taxpayers who make salary-deferral contributions to employer-sponsored 401(k), 403(b), SIMPLE, SEP, or governmental 457 plans. It is likewise available to those who contribute to traditional and/or Roth IRAs. Starting in 2018, those who made contributions to tax-advantaged savings accounts for people with disabilities and their families (known as ABLE accounts) became eligible for the saver's credit.
Depending on income levels (see chart below), the credit is worth either 10%, 20%, or 50% of a person's eligible contribution, but there are caps in place. The maximum allowable credit for those filing as Head of Household is $2,000, while married couples filing jointly may claim up to $4,000. Refundable credits and the adoption credit do not factor into the equation.
Besides falling into one of these income tiers, you’ll also need to meet the following requirements to qualify for the credit:• You are age 18 or older.• You’re not a full-time student.• No one claims you as a dependent on their return.
You also need to make contributions to either a traditional IRA, Roth IRA, SIMPLE IRA, SARSEP, 401(k), 403(b), 501(c)(18), 457(b) plan or ABLE account. Rollover contributions do not qualify.