401k Deduction

The so called 401k deduction isn't so much really a deduction as it is a deferral. This can be complicated and hard to understand but when broken down to what it really means and how it will effect your life you can figure out how to work this factor to your advantage.

The contributions to your account are taken from your paycheck each month before taxes are taken out. This means that you are not paying taxes on this money right now, giving you more money to invest and earn returns with over the years. Another advantage is that the amount you contribute is not included in your yearly income as far as the government is concerned. Because of this if you are on the border between two tax brackets and you contribute enough to your retirement savings account then you will be lowered into a lower tax bracket, meaning you pay a lower percentage of your income to taxes and save some money.

However, as mentioned in the beginning, the 401k deduction is not really that, but a deferral. You are not avoiding paying taxes on these contributions completely, you are simply deferring the payment until later. What this means is that while you won't be paying anything now, when you reach retirement age (59 years and 6 months old) you will pay taxes on this income when you make withdrawals from the account. The advantages here being that the money you would have paid in taxes in the first place was used in investments, earning you returns over all of these years and helping grow your savings, and that when you're in retirement you will hopefully fall into a lower tax bracket, lowering the amount you owe in taxes on this money overall.

This is a lot to take in and understand, but if you break up each piece you can see how this works and what the advantages and disadvantages of this system are. Some employers will also offer Roth accounts, which take your contributions from your income after taxes are already taken out, or you can look at Roth IRAs which also handle taxes in this matter. Of course if you would like to get a mix of the best of both worlds you also have the option of investing in both a traditional and Roth account. As you can see there are a lot of options available to you and it's important to taken them all into consideration and figure out how to make all of these pieces, like the 401k deduction, work for you.