Here’s How 401(k) Plans Can Cut Your Tax Bill

Source: Thinkstock

An added advantage to being an employee is working for a company that offers a 401(k). A 401(k) is a retirement plan that has several benefits and is perhaps the most strategic, no-hassle investment plan available.

Why 401(k) plans are awesome

Beyond empowering you to make perhaps the first most important financial decision in your life, 401(k) contributions are made pre-tax, therefore; you only pay taxes on your after-contribution income. This is very advantageous for those in the early stages of their careers, because it’s one way to drop to a lower income bracket and pay a lower tax rate.

To illustrate, suppose you earn a salary of $42,000 per year. For 2014, you will be taxed at a rate of 25 percent and pay taxes in the amount of $6,356, bringing your income to $35,644. However, if you make 401(k) contributions in the amount $6,356, your taxable income becomes $35,644, which puts you in the 15 percent tax bracket reducing your taxes by $1,463. I find this extremely important for early stage professionals, but it also applies to those at later stages in their careers.

Income Tax Brackets and Rates:

Rate Single Married Filing Jointly Head of Household
10% $0 to $9,075 $0 to $18,150 $0 to $12,950
15% $9,076 to $36,900 $18,151 to$73,800 $12,951 to $49,400
25% $36,901 to $89,350 $73,801 to $148,850 $49,401 to $127,550
28% $89,351 to $186,350 $148,851 to $226,850 $127,551 to $206,600
33% $186,351 to $405,100 $226,851 to $405,100 $206,601 to $405,100
35% $405,101 to 406,750 $405,101 to 457,600 $405,101 to $432,200
39.6% $406,751+ $457,601+ $432,201+

The most attractive benefit is that most corporations match as much as 100 percent of contributions up to 6 percent of your salary. Simply put, using one the most common employer contribution rates of 6 percent and the income stated above of $42,000, if you reach the 6 percent maximum contribution of $2,520, your employer would contribute an additional $2,520—that’s essentially free money.

If you’re thinking it would only reduce your pre-tax income to $39,480, what you choose to stash away is entirely up to you. The 2014 maximum contribution limit is $17,500. For those age 50 and older, the IRS allows what’s called catch-up contributions, permitting an additional $5,500.

401k plans offer hassle-free strategic investing. A major investment firm like TD Ameritrade, Vanguard, or T.Rowe Price manages the plan and has worked with your employer to offer well-allocated plan options for you to choose from. These have already been diversified among no-load mutual funds, common trusts, nonproprietary funds, and self-directed brokerage options for maximum gains.

Source: Thinkstock

Source: Thinkstock

401k plans for small business owners and self-employed individuals

If your path—like mine—has lead you to pursue being your own boss, establish an Individual 401(k) plan. To qualify your business must be a sole-proprietorship, partnership, or corporation and meet compliance testing regulations set by the IRS (additional information can be found under Section 415 of the Internal Revenue Code). However, if you are your only employee, compliance regulations do not apply.

The binary advantage of the Individual 401(k) plan is that it offers both employer and employee contributions, which means as an employee you are entitled to save the maximum $17,500 ($23,000 age 50 and older), and as an employer, match your contribution up to 25 percent of your salary or $52,000, whichever is less ($57,500 for those 50 and older).

To illustrate, let’s say you’re 53 years old and compensate yourself $100,000 per year. You max out your employee contributions at $23,000 and you, also the employer, match your contribution at 25 percent—or $25,000. Your annual contribution is $48,000. Subsequently, as previously demonstrated, you lower your tax bracket.

If you’re self-employed and have yet to set-up a sole-proprietorship, partnership or corporation, contributions are determined based on your annual net earnings after deducting half of your self-employment tax and contributions for yourself.

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Strategic retirement planning may seem intimidating, but is an art form that can be mastered. However, unless you have a plan, you will miss opportunities for growth. The painter must continually rework her canvas to create a masterpiece and an investor must see her quality of living at retirement as a canvas and discipline herself to make continued contributions.

Written by Qiana Chavaia. The views expressed represent the opinion of the author and are not intended to reflect those of FutureAdvisor or serve as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell securities. Past performance is not indicative of future results.

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