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What is a 401(k)
What is a 401(k) plan?
Announcing inflation adjustments is an annual occurrence for the IRS in its efforts to compensate for inflation before the tax filing date. With inflation being the highest it's been in decades, the IRS has announced adjustments to provide some relief to taxpayers from the rising cost of living, including significant changes to the standard deduction and Earned Income tax credit for 2024.
As a taxpayer gearing up to file your 2024 taxes on April 15, 2025, you might have questions like, “What are 2025 inflation adjustments?” or “What’s the standard deduction for 2025 after inflation adjustments?”, or you might be wondering “how much the Earned Income tax credit has increased over the past year?”
Here, we'll give you all the answers and tell you how to reduce your taxable income when paying income and self-employment taxes.
Let’s talk about 401(k)s. They’re a type of retirement plan where you can contribute a portion of your income and then choose to invest it in various stocks, bonds or mutual funds. The money you make from those investments is tax-free. When you decide to withdraw them, they will be subject to taxation.
There are a few different types of 401(k)s, and your employer chooses which ones to offer their employees. Contributing to a 401(k) can also benefit your taxes since you can claim them as a tax deduction and lower your taxable income. If you're paying estimated taxes, a low taxable income can lower your tax liability.
Key takeaways:
- 401(k)s are a type of retirement plan
- Earnings from the investments are not taxable until withdrawn
- They can be a tax benefit since you can claim your contribution as a deduction
Table of contents
What are the types of 401(k) plans?
When picking 401(k)s, you usually have two main options. The traditional 401(k) plan is the most common type of 401(k) and is offered by many employers. You can contribute with pre-tax income, thereby reducing your taxable income. Your contributions will grow tax-free until you withdraw them in retirement, at which point they will be taxed as income.
Another option is the Roth 401(k) plan, a newer type of 401(k) that is becoming increasingly popular. With a Roth 401(k), you have to contribute your after-tax income, which means you won't be able to deduct your contribution as a tax write-off. Your contributions and earnings will continue to grow and not be taxed. And even when you withdraw them in retirement, they'll still be tax-free.
The maximum contribution to a 401(k) changes from year to year. For 2023, it was $22,500 but employees over 50 years could add $7,500 as a catch-up contribution. In 2024, the limit is $23,000 and $7,500 for employees over 50.
Where you live and decide to retire can also significantly impact your decision on the best 401(k) plan for you. Let's say you're currently living and working in California, a state with a relatively high income tax rate and contributing to your 401(k) plan. You decide to retire in Nevada, a state with no income tax.
When you start withdrawing money from your 401(k) plan in retirement, you'll still have to pay federal income tax on those distributions. But because Nevada doesn't have a state income tax, you can keep more of your retirement savings.
On the other hand, if you retire in a state like New York, with a high state income tax rate, you could end up paying a significant amount of your retirement savings in state taxes. You also don’t really have to choose between the two retirement plans if you aren't sure. If your employer offers both types, you have the option to contribute to both.
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Quick tip
Visit the IRS webpage on 401(k)s and their contribution limits for a detailed breakdown.
I'm self-employed, can I have a 401(k) plan?
Yes, you can! A solo 401(k) plan is a pretty popular option among self-employed individuals. You can contribute on behalf of both the employer and the employee since you are working for yourself.
You can also cover your spouse under this plan if they profit from your business, even if they work part-time. This is particularly beneficial as you could double your contributions. But can you still deduct your contributions?
Well, this depends on your type of solo 401(k) plan you choose. If you choose a traditional solo 401(k) plan, you can deduct your contributions., You won’t have that option if you choose a Roth solo 401(k) plan.
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It is also important to mention that these tax deductions will not affect your self-employment tax, which you can calculate with a self-employed income tax calculator. They will only affect your federal income tax, calculated based on your tax bracket.
If you’re looking for specific tax deductions in your industry, you can use a 1099 tax calculator. Self-employed individuals also might have to make estimated quarterly tax payments if they owe the IRS over $1,000 in tax liability.
Missing these payments can result in penalties. A tax penalty calculator can help total your owed penalties and get you back on track. Just make sure that you pay these off as soon as possible.
Earlier we mentioned that states with high income tax rates might affect your retirement contribution withdrawals. It can also affect self-employed individuals who have to pay quarterly taxes.
A California tax calculator can help self-employed individuals living and working in California get a full breakdown of their owed taxes. If you live on the east coast in a state like New York, you can use a NYC tax calculator.
How can I get a tax refund using my 401(k)?
If you’re wondering how to get a tax refund using your 401(k) plan, there are a few ways you can reduce your taxable income and increase your chances of getting a refund. One option is contributing to your 401(k) plan before the tax year ends. This is a great way to lower your taxable income, which can help reduce your tax liability and increase your tax refund.
Another option is to explore the 401(k) loan provision, which lets you borrow up to the lesser of two options: 50% of your account balance or $50,000. While this won't necessarily result in a tax refund, it can give you some extra funds to pay off high-interest debt or invest in other opportunities that could yield a greater return.
It's important to remember that taking out a 401(k) loan can have long-term consequences, including reducing your retirement savings and incurring penalties and taxes if you can’t repay the loan on time.
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