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401(k) Savings Plans: Save More Money by Taking Advantage of Tax Breaks

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Thinking of ways to save money? Instead of focusing on increasing your income to save more, a simple way to have more money is to pay a smaller percentage of your income to taxes. There are several tax advantages designed to encourage saving for retirement which lowers your tax bill by thousands or even tens of thousands of dollars, depending on your income.

Taking advantage of these tax savings plans is a good way to save more money for retirement and pay less to Uncle Sam. The best savings rates currently available are around 1.00 percent, so you'll have to save starting now and hope for better annual returns in equities to save enough for retirement.

Early last year, I wrote an article that focused on saving for retirement and how a majority of Americans are not saving enough for their golden years. Chances are you fall into the category of Americans who are not saving enough and won't be able to retire when you would like to.

Majority of Americans are Not Saving Enough to Retire

In a Gallup poll released in 2013, only 19 percent of the people polled believed they will only need to work until their retirement age. A majority of people polled believed they will have to either work past their retirement age or would want to work past their retirement age.

40 percent of those asked about working past their retirement age said they wanted to do so, while 35 percent said they believe they will have to. Working past your retirement age isn't bad as long as that is your choice but having to work to support yourself instead of retiring is less than ideal. The only way you can possibly avoid this is by planning and saving for retirement.

We will explore 401(k) savings plans and other tax savings plans over the next several weeks. In this article, we will first go over the history of 401(k) savings plans and how they work to save you money. Then we will discuss maximizing your contributions to make sure you are saving as much as you can and lowering your tax bill as much as possible.

History of 401(K) Savings Plans

Chances are that you not only have heard of 401(k) savings plans but that you also have one or more if you have had more than one employer. You are automatically enrolled in any employer's 401(k) plan and you have to actively opt out if you do not want to participate. Not participating in your employers' plan would be a big mistake, which you will realize when you read about the benefits outlined below.

Back in 1978, there was a change in a section of the Internal Revenue Code that made 401(k) plans possible. The code change wasn't actually designed for what we now know of as 401(k) plans today. A couple of years after the code change in '78, a benefits consultant, Ted Benna, found an obscure provision and figured out that it could be used to create what is widely known as today's 401(k) plan.

Ted Benna worked for the Johnson Cos at the time and used the law to create a 401(k) plan that allowed full-time employees to fund accounts with pre-tax dollars along with matching employer contributions. Ted Benna asked the IRS to change some proposed rules under the law that ultimately led to 401(k) savings plans.

These plans came about at the perfect time in the early 1980's when companies were cutting back and eliminating the traditional pension model used for retirement, which ultimately wasn't sustainable for most companies.

Tax Advantage to 401(k) Savings Plans

Depending on what type of plan your employer has, you can put pre-tax or post-tax money into a 401(k) savings plan but the biggest advantage is the pre-tax plan. This plan allows you to put money into the account before you pay taxes. In other words, you can lower your taxable income by the amount you put into the plan.

There are annual limits on the amount of money that can be placed into a 4o1(k) savings plan. The limit for traditional 401(k) plans is $17,500 (elective deferrals) for 2014 and will probably be increased in the future for cost of living adjustments. If you're over 50, you can contribute up to $23,000 in 2014. The addition contributions allowed are know as "catch-up contributions," since at age 50 you are closer to retirement age.

By Deferring Paying Taxes on Your Savings Plan, Contributions and Earnings Ad Up

Say your taxable income is $100,000 this year and you elect to put the maximum allowed amount of $17,500 into your 401(k) plan. Your taxable income is immediately reduced from $100,000 to $82,500. If you're in a 25 percent tax bracket, you would reduce your tax bill by $4,375 a year at the current maximum contribution. Multiply this tax savings by 20, 30 or 40 years and  the savings add up.

Putting pretax money into a 401(k) savings plan only defers you from paying taxes. Ultimately, when you withdrawal the money in retirement you'll have to pay taxes. When you reach age 70 ½, there are mandatory withdrawal requirements called "minimum distributions." The only way to avoid minimum distributions is to continue working past age 70 ½.

Another tax benefit to both pre-tax and post-tax plans is earnings in the account grow tax-deferred. Those earnings include interest, dividends, and capital gains - all grow tax-deferred. Compounding earnings with delayed taxation on gains is probably the biggest benefit to 401(k) plans.

For example, say you have $250,000 in your 401(k) plan and the plan earns a return of 10 percent this year, earning the account $25,000. Since you don't have to pay taxes on the $25,000 earned, the following year the account has $275,000 in it. A higher amount as opposed to a lesser amount of taxes had to be paid. Compounded over decades, the earnings add up to hundreds of thousands or even millions of dollars, depending on the amount in the account and the returns over the years.

Employers Match 401(k) Savings Plan Contributions

Most employers also will make annual contributions to your 401(k) plan. You are being given free money to save money - this is the best incentive to save and contribute the maximum amount you possibly can to your 401(k). Employer matching contributions differ with each employer but you need make sure you are getting the maximum amount from your employer.

Employer contributions can be in the thousands of dollars, so it would be foolish not to take this "free money." Your employer might match 50 percent of your total contributions up to a certain amount or even 100 percent of your total contributions up to a certain dollar amount.

Overall Limit on Contributions

As we stated above, there is a maximum amount of $17,500 for elective deferrals in 2014 but there is also an overall contribution limit that are a lot higher. The overall annual contributions to all of your accounts including elective deferrals, employee contributions, employer matching, and discretionary contributions, can be as high as 100% of your compensation or $52,000 for 2014.

If you're in a position to financially contribute more to your retirement accounts, you should be doing so by taking advantage of overall contribution maximums. There are other creative ways to help save for retirement including using a Health Savings Account (HSA) as another retirement account.

Don't be part of the 35 percent that want to retire on time but believe they won't be able to because they are not saving enough.
Author: Brian McKay
February 17th, 2014