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Employee Savings Through 401Ks Get Triple Savings on Taxes

by
Gordon W. McNamee
on
11/15/2021
Employee Savings Through 401Ks Get Triple Savings on Taxes

Does your employer offer a 401k plan as a benefit? It's one of the most popular perks a company can provide, and there's a good reason for that. 401k plans offer triple savings on taxes and one of the best savings strategies around. Retirement may seem like it's a long way off, and you may be tempted to stash your cash in a more accessible account. This article will explain the basics of 401k savings, and why you should not think twice about signing up.

What is a 401k plan and how does it work?

Subsection 401K of the tax code gave employers an incentive to offer their employees special retirement accounts in which each enrolled employee allocates a percentage of pre-tax dollars to get deposited into their savings account each week. These deposits get invested in mutual funds and other types of monetary assets that grow tax free. What makes a 401k particularly attractive is that employers have the ability to match the employee's contributions up to a dollar-for-dollar amount, thus greatly boosting the amount that is saved.

The employer match may be the most obvious advantage of 401k plans, but it is by no means the only one. 401k contributors also get triple savings on taxes and have their savings sheltered from creditors in case of a bankruptcy. Let's take a look at each.

  • Matching contributions from employer – Though the amount that your employer offers as a match is entirely up to them, any amount they contribute grows your savings faster, and is offered to you without being taxed or counting as income. 
  • Triple savings on taxes – There are so many tax savings offered to 401k participants that it is almost hard to appreciate all of them. The most obvious advantage is that the income you invest in the account is pre-tax, which means that it has greater value to your savings than money you've earned that has already had taxes deducted. The second is that by virtue of investing pre-tax dollars, you lower your annual income and therefore may pay less in income tax. Finally, as your investments grow, they are not taxed in the same way that is true of regular savings accounts. They are not taxed until you deduct them, which is usually during retirement – and at a time when many people's incomes are lower, and therefore subject to a lower tax bracket. 
  • Funds are protected in case of a bankruptcy filing – If you ever need to file for bankruptcy and your assets are subject to judgments, your retirement plans are protected under the Employee Retirement Income Security Act of 1974.

There is a wide range of 401k offerings available to employers, but they have the option of allowing employees to invest as much as $19,500 per year, and employees over 50 can set aside an extra $6,500 as a way to maximize their savings before retirement.

Taking money out of your 401k

Because 401k plans are specifically designed to encourage retirement savings, the government takes a dim view of withdrawals before the age of 59 ½ and imposes a penalty for those who do. Taking funds out before the age of 55 ½ creates a 10% early withdrawal penalty, and this is on top of the taxes that are always incurred when 401k funds are withdrawn. Once you have reached the age of 59 ½ you will be able to withdraw money with no fines, and the amount that you withdraw will be subject to taxation based on your income tax bracket. Though you can choose to delay withdrawing funds and allow your investments to continue growing, once you reach the age of 72 the IRS forces retirement savers to take an annual required minimum distribution.

Many employees are hesitant about starting a 401k with one employer out of concern that they will lose their savings if they ever switch jobs. However, 401k investors have the ability to roll their savings over into either an individual retirement account (IRA) – which is another type of tax-deferred account independent of employment -  or they can transfer their savings directly into their new employer's 401k plan without being subjected to penalties. The only way that penalties would be imposed would be if they chose to withdraw their funds as cash. 

Maximizing Your 401k

Because the 401k has so many benefits, financial experts urge retirement savers to put enough of their income into a 401k account up to the maximum that will be matched by their employer's program and then switch your savings into a Roth IRA up to the limit allowed by your income. Once that amount has been reached, funds still available for retirement savings are probably best saved by reactivating your 401k election. The goal is to save between 10 and 15 percent each year for retirement. 

If you need assistance in determining the best retirement savings option for your specific situation, a CPA can help.

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Gordon W. McNamee

Gordon W. McNamee

Gordon W. McNamee is a Certified Public Accountant (CPA) based in Rancho Cucamonga, CA. Gordon W. McNamee can assist you with your tax return preparation, payroll, accounting and tax planning needs. <br /> <br /> 2021 is Gordon W. McNamee, CPAs 38th year in the profession. As as a former IRS agent (1984 through 1987), Gordon has been in public accounting since 1987. Gordon specializes in individual, corporate, HOA, trust, estate and payroll taxes. He also prepares financial statements and provides accounting & bookkeeping services. He enjoys making his clients feel at ease while providing a personalized professional service.

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