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Supercharge Your 401(k) Tax Planning

Tax deductions aren’t the only benefit of 401(k)s. Here are some often missed ways to use your 401(k) to supercharge your tax planning.

401(k) Tax Deduction

The contributions to a 401(k) plan are generally deductible from the employee’s taxable income in the year they are made.

When you contribute to your 401(k) plan, the money is taken out of your paycheck before taxes are withheld. This means that your taxable income is reduced by the amount of your contribution, which can lower your overall tax bill. For example, if you earn $50,000 per year and contribute $5,000 to your 401(k), your taxable income for the year is reduced to $45,000.

The IRS sets limits on how much you can contribute to a 401(k) plan each year. For 2023, the contribution limit is $22,500 for employees under age 50. If you are age 50 or older, you can make an additional catch-up contribution of $7,500, bringing your total contribution limit to $30,000.

It’s important to note that there are also limits on the total amount of contributions that can be made to a 401(k) plan each year, including both employee and employer contributions. For 2023, the combined contribution limit is $66,000, or $73,500 if you are age 50 or older.

Roth 401(k) Alternative

A Roth 401(k) is a special type of retirement savings account that combines features of a traditional 401(k) and a Roth IRA.

When you contribute to a Roth 401(k), the money is taken out of your paycheck after taxes are withheld. This means that your contributions are made with after-tax dollars, and you won’t get a tax deduction for your contributions in the year they are made.

However, your earnings will grow tax-free, and you won’t owe any taxes when you withdraw the money in retirement, as long as you meet certain requirements. That’s normally being at least age 59 1/2 and having held the account for at least 5 years, but there are other exceptions like a 401(k) hardship withdrawal.

A Roth 401(k) can be a good option if you think your taxes will be higher in retirement than they are now. By paying taxes on your contributions upfront, you can avoid paying taxes on your withdrawals in retirement, when you may be in a higher tax bracket.

Another reason to consider a Roth 401(k) is to diversify your tax strategy. By having both a traditional 401(k) and a Roth 401(k), you can choose whether to make taxable or tax-free withdrawals depending on your current income.

If you want to use both a Roth and traditional 401(k), you can contribute to both in the same year. The 401(k) contribution limits are shared between both types of 401(k).

You can divide up your contributions however you want to. It doesn’t need to be 50/50.

401(k) Withdrawals and Social Security

401(k) withdrawals can impact the taxability of Social Security benefits because Social Security benefits are subject to income tax if your provisional income exceeds certain thresholds. Provisional income is defined as the sum of your adjusted gross income, nontaxable interest, and half of your Social Security benefits.

If your provisional income is below $25,000 for single filers or $32,000 for joint filers, your Social Security benefits are generally not taxable. However, if your provisional income is between $25,000 and $34,000 for single filers or between $32,000 and $44,000 for joint filers, up to 50% of your Social Security benefits may be taxable. If your provisional income exceeds $34,000 for single filers or $44,000 for joint filers, up to 85% of your Social Security benefits may be taxable.

To reduce or avoid taxes on your Social Security benefits, you may consider taking more 401(k) withdrawals before you start receiving Social Security. The goal is to keep your annual income and tax bill relatively consistent rather than having low income and low taxes in early retirement and high income and high taxes once your Social Security benefits start.

Another option is to use a Roth 401(k). Since Roth 401(k) withdrawals are tax-free, they do not impact your provisional income or make your Social Security taxable.

You may also want to consider delaying taking your Social Security benefits. This gives you more time to use up your taxable retirement accounts and also increases your later Social Security benefit.

It’s important to note that everyone’s situation is different, and there are many factors to consider when making retirement and tax planning decisions. Consulting with a financial advisor or tax professional can help you determine the best strategy for your individual situation.

401(k) Withdrawals and Pensions

If you have a pension, you also need to think about how to time your 401(k) withdrawals. Pensions are almost always taxable, so receiving a pension and taking 401(k) withdrawals in the same year can push you into a higher tax bracket.

You’ll want to consider similar strategies to the above for Social Security:

  • Take bigger 401(k) withdrawals before your pension starts
  • Use a Roth 401(k)
  • Consider alternative pension payment schedules if available (such as reduced payments in exchange for covering your surviving spouse or increased payments for delaying when your pension payments start)

401(k) Required Minimum Distributions

Another important 401(k) tax planning consideration is Required Minimum Distributions (RMDs). You can’t just leave your money in your 401(k) until you need or leave it to your grandchildren if you don’t.

Once you turn age 72 (previously 70.5), you’re required to take annual distributions from your 401(k). You must take at least the RMD amount each year but can take more if you choose.

At age 72, the RMD is about 3.6% of your account balance. At age 80, it’s about 5%. At age 90, it’s about 8%.

Those withdrawals get added to your taxable income and can make your Social Security taxable or increase your tax rate on other income.

So depending on your Social Security and other retirement income, you may want to start drawing down your 401(k) sooner to reduce your future taxes. Again, you’re looking to smooth your income out over your retirement instead of having a big jump in income and taxes when you turn 72 and have to start taking RMDs.

Making Charitable Contributions

If you have more money than you need and want to reduce your tax bill or avoid RMDs, one way you can do it is by making charitable contributions. Cash donations up to the annual charitable contribution limit reduce your taxable income by the amount of the donation.

Another option is to make a Qualified Charitable Distribution (QCD). A QCD lets you donate up to $100,000 per year directly from an IRA once you reach age 72.

Further, QCDs count towards your annual IRA RMDs. So if your QCD is equal to or greater than your RMD, you don’t need to take an RMD that year.

You don’t get a tax deduction for a QCD, but you also don’t have to pay taxes on it. It also doesn’t count toward your cash contribution limits.

QCDs are normally only for 401(k)s, but there’s an easy way to get around that. Once you leave your job, you can generally roll over all or part of your 401(k) into an IRA.

There are no taxes or penalties when you roll a traditional 401(k) into a traditional IRA. After you do the rollover, your 401(k) RMDs are based on the new, lower balance of your 401(k).

Using 401(k) Contributions to Get Other Tax Benefits

Many other tax benefits have Adjusted Gross Income limits. Examples include:

  • IRA deductions
  • Affordable Care Act health insurance subsidies
  • Student loan interest deduction

Deductible 401(k) contributions reduce your AGI and make you eligible for tax benefits that you wouldn’t qualify for based on your gross income without deductions. So if your annual salary is near the cutoff for a tax benefit you want, check to see if you should put more into your 401(k).