March Madness is upon us, and while college basketball fans across the country are busy trying to avoid any bracket busters, this is the time to focus on your tax bracket as well. Whether or not you're looking forward to your annual April 15th tip-off with Uncle Sam, there are measures you can take now to help reduce your tax burden for 2015 and beyond using a savings vehicle that's likely already part of your financial lineup. A workplace 401(k) plan is not only one of the best ways to save for retirement, it also nets a number of important tax benefits. Here are the top five 401(k) moves that could help you make more of every tax season:
- Commit to contributing. With a traditional 401(k) plan, pre-tax contributions are deducted from your paycheck before federal income taxes are withheld, effectively lowering your taxable income. If you make a significant contribution, you might put yourself into a lower tax bracket altogether, which allows you to keep even more of your pay.
- Get to know the Roth. By design, a Roth 401(k) offers a different strategic tax planning opportunity than a traditional 401(k). With a Roth 401(k), contributions are made on an after-tax basis, and distributions of any investment earnings are tax-free after you meet certain requirements. This kind of plan could make sense for young professionals and anyone else who anticipates retiring in a higher tax bracket, and also can offer other tax and estate planning advantages.
- Score some extra credit. Depending on your income and filing status, you may be able to lower your tax bill even further by taking advantage of the Retirement Savings Contributions Credit, also known as the Saver's Credit. Introduced by the IRS in 2002, the credit's purpose is to directly reduce your taxable income by a percentage of the amount you contribute to your 401(k) plan. According to the IRS, those who meet eligibility requirements can take a credit of up to $2,000 (or $4,000 if you're married and filing jointly), so it's definitely worth exploring.
- Resist the urge to withdraw. While pulling money out of your 401(k) might seem like a quick fix when you're strapped for cash, doing so can come with hefty tax penalties. In fact, if you withdraw money from your employer-sponsored retirement plan before age 59½, you'll likely face a 10 percent federal penalty. In addition, the government will take 20 percent of your withdrawals as an advance on your tax bill. Also, keep in mind, some plans may bar employees who have taken a withdrawal from contributing for the next six months, further derailing your savings plan.
- Leave loans alone. As I always say, taking a loan from your 401(k) should only be done as a last resort. There are a number of negative consequences associated with 401(k) loans, especially from a tax perspective. For one, you must repay the loan with after-tax dollars, negating many of the great tax benefits of the 401(k). Additionally, if you leave your job before you pay back the loan in full, your outstanding balance is treated as a withdrawal, spurring a tax bill and potentially an additional 10 percent penalty.
Armed with these tips, you can face April 15th knowing that one of your most fundamental savings tools, your 401(k), is working to help you manage your tax burden. If professional advice is available as part of your plan, it's a good place to turn to understand some of the options discussed above.
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