How are contributions from wages to an employer retirement plan such as 401(k) generally treated for tax reasons?
Answer (2)
Contributions to a 401(k) plan are typically made with pre-tax dollars, reducing an employee's taxable income. The funds grow tax-deferred until withdrawal, at which point they are taxed as ordinary income. Employee contributions are subject to IRS limits, but employers may also provide matching contributions that grow tax-deferred.
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Contributions from wages to an employer retirement plan, such as a 401(k), are typically treated in a tax-advantageous way. Here’s a step-by-step explanation of how this works:
Pre-Tax Contributions: When you contribute to a traditional 401(k) plan, the contributions are made with pre-tax dollars. This means that the money you contribute is deducted from your taxable income for the year. For example, if your salary is $50,000 and you contribute $5,000 to your 401(k), you will only be taxed on $45,000 for that year. This reduces your current taxable income, which may lower your overall income tax liability.
Tax-Deferred Growth: Once the money is in your 401(k), it can be invested in various options such as stocks, bonds, and mutual funds. The growth of these investments (interest, dividends, and capital gains) is not taxed as long as the money remains within the plan. This allows your investments to grow potentially faster than they might in a taxable account, thanks to the power of compounding without immediate tax deductions.
Taxation Upon Withdrawal: The money is only taxed when you withdraw it, typically during retirement. Withdrawals are taxed as ordinary income. This system works under the assumption that you may be in a lower tax bracket when you retire compared to your working years, potentially lowering the tax impact of withdrawals.
Contribution Limits: It's important to note that there are annual limits on how much you can contribute to a 401(k). For 2023, the limit is $22,500 for individuals under 50, with an additional catch-up contribution limit of $7,500 for those 50 and older.
The key benefit of a 401(k) is the tax deferral, which can result in significant tax savings over time and provide a robust savings mechanism for retirement.
