Tax Advantages of Contributing Towards 401(k)

Making a retirement fund does not seem to be a priority for most people. Those who are young feel that it is too early to start saving for retirement when there are always other payments to make. However, there are many reasons why you should start taking your 401(k) contributions seriously. Other than your employer’s contribution for building your fund, there are many tax benefits of contributing to 401(k) as well.

Tax savings at time of contribution

The first time you will save tax is when you make the initial contribution to 401(k) as your contribution goes from your pretax dollars. You do not have to pay any tax on the money you deposited in your 401(k) as that amount is not included in your taxable income for that year. The entire amount will go into your retirement fund and nothing will be deducted as taxes.

It is true that the money you put in your 401(k) will be inaccessible for some time, but this is offset by twin advantages that you get by making these contributions.

Tax deferral for 401(k) gains

Another advantage with 401(k) is tax deferral. This means you do not have to pay any tax right now on the interest, dividend or capital gains that accrue in your 401(k) account. The tax is deferred until you withdraw the 401(k) money.

Tax deferral is a major incentive when your take into account the compounding nature of returns. The amount that should have been paid as tax will continue to remain in the 401(k) account for many years, which means you will earn interest or returns on it. By the time you pay tax when withdrawing this amount, you would have already earned substantial returns on it. This will increase your overall retirement savings.

Tax benefit at the time of withdrawal

Another advantage is that the money you withdraw from 401(k) will most likely be subject to a lesser tax rate as your income bracket will be lower after you retire. However, if you are earning more at the time of withdrawing the amount, then you might not get this advantage.

I strongly recommend that you start making 401(k) contributions as early as possible in your life to gain from these tax benefits. Not only will you reduce the amount of money you pay as taxes, you will also secure your future.