If you have recently taken up a position at a brand-new company and opened a 401k for the first time, you may be on the hunt for additional information when it comes to the various ways in which tax can impact your contributions. It can be difficult to know where to begin, especially if you have little to no experience of owning a 401k, but by familiarizing yourself with the following information, you can find out everything you could ever want or need to know about 401ks and start benefiting from a number of tax benefits in the process.
It can allow you to make pre-tax contributions
If you are unfamiliar with owning a 401k, it may benefit you to know that any contributions to a traditional 401k tend to be paid directly from your monthly wages before any income taxes are withheld. This can lower your total taxable income, lead to you owing less in income taxes regardless of whether you decide to opt for itemisation or standard deduction and, last but certainly not least, may even result in you falling within a tax bracket which is lower. It may also surprise you to know that your pre-tax contributions are tax-deferred until you choose to eventually withdraw them during retirement with the underlying theory that whilst in retirement, you will find yourself in a tax bracket which is lower than you would be if you were taxed on the money in the present day.
It can accumulate tax-deferred interest
If you are familiar with the process of saving money in a traditional savings account, you may already be aware that you must pay taxes on any interest that it earns on an annual basis. If you opt for a tax-deferred 401k, however, you can end up saving a considerable amount of money on the taxes of the earnings of your contributions. If you were to contribute a minimum of $100 a month into a traditional 401k that earns 8%, for example, you may be able to walk away with more than $150,000 of tax-free savings over the course of 30 years and save more than a total of $50,000 in taxes in the process with your earnings continuing to compound year after year. It may, however, benefit you to know that required minimum distributions, or RMDs, must be taken annually from the age of 72 from traditional IRAs and 401ks with the process of calculating your required minimum distribution perhaps requiring a little clarification beforehand.
It can allow for tax-loss harvesting
If you are interested in reducing your 401k taxes, tax-loss harvesting may be a viable option for you. It, in the very simplest of terms, involves selling underperforming securities that are actively losing you money in your traditional investment account with the losses on the securities usually counterbalancing the taxes on your 401k distribution. It may also be entirely possible to completely offset your tax burden from a 401k distribution by tax-harvesting with the loss reducing your taxable capital gains and perhaps even allowing you to offset it by a staggering $3,000 of your normal income.
It can defer taxable income until retirement by rolling over
If you are still in employment, it is not necessary to take distributions on your 401k with your current employer. If you have a 401k with a former employer, however, it may benefit you to take RMDs from those accounts. It may be possible to avoid this requirement, however, by rolling any old 401ks into your current 401k before you turn 72 with this allowing you to take advantage of a number of benefits including to defer further taxable income until the time you reach retirement age when your distributions will fall within a lower tax bracket if you are no longer actively earning income. It may also be worth knowing, if you don’t already, that RMDs were waived in 2020.
It can impact any early withdrawals
If you are in the process of saving for retirement, your first option when you find yourself in a financial pickle may not necessarily be to withdraw from your 401k early. If you have been left with no suitable alternative, however, it is entirely possible to do so but you will be responsible for paying taxes on any withdrawals regardless of whether you are retired or are only nearing retirement. This can potentially result in a raised tax bill for the entire year with the amount that it is ultimately raised by dependent on how much money you withdrew early and how much annual income you are actively earning throughout the year. If you are under the age of 59 when you withdraw, for example, you will also be forced to pay a 10% early withdrawal penalty. If you are eligible for a number of minor exceptions, such as being required to pay medical expenses, a first-home purchase, or becoming permanently disabled, however, you may be able to waive the 10% early withdrawal penalty, but you will still be expected to pay taxes.
If you are curious as to how tax can impact your 401k, there are a number of things you must know. It can, for example, allow you to make pre-tax contributions, accumulate tax-deferred interest, allow for tax-loss harvesting, defer taxable income until retirement by rolling over, and, last but certainly not least, can also impact any early withdrawals with taxes still required to be paid if you withdrawal early.