5 Great Tax Reasons for Contributing to a 401(k) Plan

JK Lasser writes: If you work for a company that offers a 401(k) retirement plan, think long and hard about what you want to contribute for 2014. The maximum contribution is $17,500 (plus $5,500 if you’ll be 50 or older by the end of 2014). You probably need to commit to your 2014 contribution now. There are 5 tax reasons for adding as much as you can.

1.         Salary contributions aren’t taxed

The amount you add to a 401(k) plan is not currently taxable. Thus, if your compensation is $45,000 and you add $6,000 to the plan, your taxable wages for the year are $39,000. However, the deferred amount is still taken into account for FICA purposes, so you’ll accrue Social Security credits based on the salary you receive plus the amount you contribute to the plan.

Even better than income tax deferral is the fact that by lowering your adjusted gross income (AGI) by the amount of your contribution, you may qualify for a variety of tax benefits that have eligibility limits based on AGI. And if you are a high-income taxpayer, you may reduce or avoid the phase-out on exemptions and itemized deductions. Thus, your tax savings can be much greater than simply the tax saved on the portion of compensation added to the plan.

2.         Contributions may generate a tax credit

The tax law lets you double dip by enjoying tax deferral as well as taking a tax credit. The retirement savers credit is up to 50% of deferrals up to $2,000 (top credit of $1,000); the credit percentage of 10%, 20%, or 50% depends on your filing status and modified adjusted gross income (MAGI). For 2014, some credit is still allowed for joint filers with MAGI up to $60,000 ($27,000 for singles; $29,250 for heads of households).

3.         Employer contributions aren’t current income

Many employers make matching contributions to encourage participation or reward employees in the plan. Their contribution formulas may vary; usually they do not exceed 6% of compensation. Whatever amount is contributed by your employer to your account, it is not included in gross income now. You’ll pay tax on the contributions when you take distributions, which may not be until you retire and are in a lower tax bracket than you’re in when the contributions were made.

4.         Borrowing lets you tap funds without tax

If you have an immediate need for cash, you can get it quickly by borrowing from your own account. Your credit score doesn’t matter and interest rates are low. All you need to do is ask your plan administrator for a loan; you don’t have to specify why.

The most you can borrow is 50% of your account balance or $50,000, whichever is less. You have to repay the loan in level amounts over no more than 5 years (longer if the funds are used to buy a home), but you can pay it off more quickly with no penalty. If you’re married, you’ll need your spouse’s consent to the loan.

5.         Distributions are exempt from the NII tax

Distributions from qualified retirement plans and IRAs are not treated as net investment income (NII) for purposes of the 3.8% additional Medicare tax on net investment income. However, the distributions do count as part of MAGI, which could nonetheless help to trigger or raise the NII tax.

Conclusion

If you can’t afford to contribute the maximum, try to add as much as required to earn the maximum employer contribution. Working spouses with limited funds to contribute should coordinate their annual elective deferrals. When in doubt, talk with a tax advisor.