401(K) IRS Deductions
The 401(K) Retirement plan is a method established by the IRS that allows an employee to save for retirement while at the same time deferring his tax obligation to a later date. Where is this deduction taken on your tax forms?
The 401(k) plan is named after a section in the IRS codes. It is a type of retirement plan that is established for employees. It allows them to save a certain portion of their income in a plan that is designed to produce earnings while at the same time deferring a portion of the current tax obligation. The word deferring is used because the tax on the earnings will be paid eventually. The idea behind the 401(K) is that after retirement age, earning will be reduced and deductions higher and this would be a better time to assume the tax obligation than at the current time.
The amount of income that can be deposited to the 401(k) plan in any given year is limited. The limit for the 2007 tax year is $15,500. This might be subject to an additional limit imposed by the company that administers the plan. Most tax experts advise you to max out your contributions whenever possible. This indicates the value of the 401(K) plan in the eyes of most tax experts.
The reason for this is that the amount of the contribution is not taken as a deduction on your tax forms. It does not even appear on your form W-2 as taxable income. For example, if you earn $50,000 in actual earnings for the year, and commit the maximum allowable amount to your 401(k), your W-2 will indicate only $34,500 of taxable earnings. This will result in a substantial reduction in tax obligation even before any other deductions or credits are applied.
The $15,500 will be invested in various ways while in your 401(k) and will produce earnings. These earnings will not be subject to tax either until they are withdrawn after retirement. The 401(k) plan has only a few drawbacks and they mostly involve withdrawing of the funds before retirement age. It is possible to make emergency withdrawals, in the case of legitimate emergencies, but normal withdrawals before the age of 59 and a half are subject to not only normal taxation, but also a 10% excise tax.
The 401(k) plan, when used as intended, is an excellent way to reduce your tax obligations by reducing your taxable income. Once the plan is established, it requires no special work at tax time, as the money invested in the plan does not appear on the W-2 as income. The tax problems will be deferred until after retirement when the distributions from the plan are taken. The distributions, contributions and earnings, will be treated as regular income and will be subject to the tax rates in effect at that time. Plans known as Roth 401(k) plans have the contributions made after the taxes are paid, and the distributions are then tax free. The above information is for non-Roth 401(k) plans.