401k Tax Savings Basics
The money you put into a 401k plan acts as an "above-the-line" tax deduction. When you file your income tax return, you must decide whether to use a standard deduction provided by the IRS or a sum of your itemized deductions, which include expenses such as property taxes and home mortgage interest. Above-the-line tax deductions apply whether you decide to take the standard deduction or your itemized deductions. The amount of tax savings you receive for contributing to a 401k plan in a given tax year equals the amount of your contributions multiplied by your tax rate. For example, Bankrate states that single filers who earned between $8,376 and $34,000 are subject to a 15 percent top tax rate for 2010 tax returns. If you earned $30,000 and contributed $5,000 to a 401k in 2010, you would have paid $750 less in taxes.
Filing Status and Income
Tax rates vary depending on your tax filing status and income level. Filing statuses include single, married filing jointly, married filing separately and head of household. A single worker who makes $150,000 a year will have more tax savings if he contributes $5,000 to a 401k plan than a married couple that saves the same amount but makes $50,000 and files jointly, because the single taxpayer faces a 28 percent top tax rate while the married couple faces a 15 percent top tax rate.
Falling to a Lower Tax Bracket
If your income and tax filing status place you just above a certain tax bracket, a 401k contribution may cause you to fall into a lower tax bracket. For example, if you earned $35,001 as a single taxpayer, $1,000 of your income would be subject to the 25 percent tax rate. If you contributed $5,000 to a 401k, you would save $250 on the $1,000 of income that exceeded $34,000 and 15 percent on the remaining $4,000, for a total savings of $850. The more income you make, the more you stand to save on taxes from contributing to a 401k.
Taxes on Distributions
While 401k plan contributions reduce your taxes for the year that you make them, you owe income taxes on the money you withdraw during retirement. In other words, 401k contributions delay rather than avoid taxation. Because many people have less income during retirement than they do during working years, tax rates on 401k withdrawals may end up being lower than your tax rates when you make the contributions.