If you have a 401(k) plan at work, you may be wondering how it affects taxes. Many people discover too late, in retirement, that they didn’t save enough for a good life in their senior years. Others regret making the wrong decision when choosing pension plans. Therefore, it’s important to understand the tax implications of your retirement savings scheme.
A variety of retirement savings plans exist. While many are available to everyone, some can only be accessed through your employer. An example is the 401(k), an employer-sponsored pension plan that not all companies offer.
For companies that offer 401(k) plans, contributions are taken straight from your paycheck and sent to the plan. The company may also match your contribution. Because 401(k) contributions are automatically deducted, you just need to set them up and leave them.
The funds are usually invested in securities, such as stocks and bonds, so that the money can grow over time. Depending on the plan your company provides, you may be able to choose where you contribution is invested. For example, some plans now offer cryptocurrencies alongside traditional investments: Coinbase has partnered with a 401(k) plan provider to allow workers at participating companies to put up to 5 percent of their funds toward Bitcoin and other cryptos.
The 401(k) contribution limits, explained
The IRS sets the contribution limit for 401(k) plans and reviews it regularly. In 2022, you can contribute up to $20,500 to a 401(k) plan, up from $19,500 in 2021 and 2020. If you’re over 50, the IRS allows you more room to catch up with your retirement savings. As a result, you can contribute up to $6,500 over the standard limit, which puts the maximum at $27,000 in 2022. You may want to note that company matching doesn’t count toward individual 401(k) contribution limits.
Types of 401(k) plans
If you work for a company that offers a 401(k), you may be able to choose between a traditional 401(k) or a Roth 401(k), or take both. The traditional 401(k) stemmed from a 1978 tax code (which also provides the basis of its name), and the Roth 401(k) is a more recent version that was introduced in 2006.
Whereas both plans automatically take contributions from your paycheck to fund your retirement account, they differ in the tax treatment of the contributions. With a traditional 401(k), contributions are taken from your paycheck before taxes. On the other hand, Roth 401(k) contributions are taken after taxes.
How 401(k) plans affect taxes
In a traditional 401(k), you make tax-free contributions to the fund. At the same time, you reduce your current taxable income, which means a lower tax bill. While your money grows tax-free in the plan, withdrawals in retirement will be taxed as ordinary income at the application rate.
In a Roth 401(k), you send money to the fund after paying taxes on it. Whereas you don’t get to lower your taxable income now, your withdrawals in retirement will be tax-free.
If you want to take more money home from your paycheck, a traditional 401(k) may be the way to go. But if you want to do away with tax headaches in retirement, especially if you think tax rates could go up in the future, Roth 401(k) may be ideal. You can start taking 401(k) withdrawals at age 60. Early withdrawals may attract a penalty.
While a Roth 401(k) saves you taxes in the future and you can have more money in retirement, it may not be best in every situation. You need to hold a Roth 401(k) plan for at least five years before you can start taking withdrawals. And that may be an inconvenience to someone who has started one when they’re just about to retire.