It's been a rough winter for most of the country. And, if you think Mother Nature hits hard, just wait a few weeks until Uncle Sam gets a crack at us. Millions will owe money to the government, but there's still time to help reduce your tax burden for this year and beyond. A good place to start is with your workplace 401(k) plan. While the 401(k) is designed to help you save more for retirement, it can also lessen your tax blow for 2014. Here's a look at what you need to know:
- Try to increase or max out your contributions. Traditional 401(k) plans are funded with pre-tax dollars, which means your current taxable income is lowered. Making a significant contribution could bump you down into a lower tax bracket entirely, allowing you to keep even more of your pay. An Employee Benefit Research Institute report found that only 10% of participants were maxing out their contributions, so there is room to get more aggressive with your savings rate. *
- Get extra credit. Based on your income and filing status, contributions to a qualified 401(k) plan may even further lower your tax bill through the saver's credit or retirement savings contributions credit. The credit was established in 2002 and directly reduces your taxable income by a percentage of the amount you put into your 401(k) plan. According to the IRS, those who meet eligibility requirements can take a credit of up to2,000, so it's definitely worth investigating.
- Consider a Roth 401(k). A Roth 401(k) can offer a different kind of strategic tax planning opportunity. In a traditional 401(k) plan, contributions are made on a pre-tax basis and taxes are paid when you take distributions from the plan. In 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.
- Withdrawals are tax burdens. Any withdrawal from a 401(k) plan can carry significant tax consequences. How significant? If you take money out of your employer-sponsored retirement plan before the age of 59½, you'll likely face a 10% federal penalty. What's more, the government will take 20% of your withdrawal as an advance on your tax bill. Plus, some plans may freeze employees who have taken a withdrawal from contributing for the next six months, hurting retirement savings even further.
- Avoid the loan. Borrowing from your 401(k) should be an absolute last resort. Loans from a 401(k) plan must be repaid with after-tax dollars, negating much of the tax benefits of a 401(k). And if you leave your job and are unable to repay the loan in full, the outstanding balance is treated like a withdrawal, triggering a tax bill and possibly a 10% penalty on top of the tax.
* Ruth Helman, Nevin Adams, Craig Copeland, and Jack VanDerhei, "2013 Retirement Confidence Survey: Perceived Savings Needs Outpace Reality for Many," EBRI Issue Brief, no. 384, March 2013.