How to Use your 401(k) to Reduce Taxable Income

Your 401(k) plan provides an excellent opportunity to reduce your tax liability. It can help you save for retirement, but more importantly, your     401(k) can be a valuable way to reduce the amount of tax you owe on an annual basis. You should also check to see if your employer has a matching program; if they do and you’re not taking advantage of it, you could be leaving money on the table.

Maximizing your 401(k) contributions

For the 2017 tax year, the IRS allows you to contribute up to $18,000 to your 401(k) plans. In addition, those who are over the age of 50 can contribute an additional $6,000. Planning to save the maximum amount per paycheck, in pre-tax dollars lowers your taxable liability by reducing your taxable income.

Make sure to check your tax brackets before making your final contribution for the year. If you have not maxed out your contribution limit, you could reduce your tax liability if your tax bracket is decreased. This is in addition to the overall deductions you are entitled to for your 401(k) contributions.

Using 401(k) loans versus distributions

For some, taking a 401(k) distribution for a hardship becomes necessary. Keep in mind, these distributions are taxable; you could be paying additional state, and federal taxes, as well as a penalty for early withdrawal. Before applying for a hardship withdrawal, discuss the potential of taking a loan against your vested balance. Many plans offer participants the ability to borrow up to 50 percent of their vested balance; you would not incur a penalty, nor would you have an additional tax liability if you elect to borrow money.

Plan ahead for next year

Since the current tax year is nearly over, you may not have time to make the maximum contribution to your 401(k) plans this year; however, it is not too soon to start planning for next year. If you receive a pay increase, consider increasing your 401(k) contributions by the same amount. Additionally, if you are placing funds in an outside IRA or ROTH plan, you may find that increasing your 401(k) contributions helps you reduce your tax burden more than these plans.

For individual taxpayers, and small business owners, reducing taxable income means a lower tax burden; if you need an evaluation of your current 401(k) contributions, and guidance on how maximizing your contributions can reduce your taxable income, contact Rue & Associates, Inc. Our team has more than three decades of experience helping you make smarter tax decisions.