By Rodney A. Brooks
The tax filing deadline is coming at us fast. Hopefully, most of us have already filed and are sitting home waiting for that refund. But that doesn’t mean you shouldn’t start thinking about how to reduce taxes in the future.
One of the best ways to reduce your taxes now or in the future is to contribute to a 401(k) or a 403(b). Here are three 401(k) tax tips for people of all ages, but they are especially relevant for Millennials and Gen Z’ers.
If you work for a company that offers a 401(k) plan, make sure you participate. If you can, contribute 10 percent of your salary. If you can’t afford to contribute the full 10 percent, then contribute at least up to the company match, which is usually about 4 percent of your salary. That 4 percent is what financial people call free money.
Using a Bankrate.com compound interest calculator: For this example, let’s start with $1,000 in your 401(k) account beginning at the age of 30 and contribute 10 percent of your salary. Assume a salary of $45,000 and an employer match of 4 percent. If you retire at 65 and you’ll have nearly $900,000 saved.
If your employer offers a 401(k) you should see if they offer a Roth option. If they do, you should consider putting half of your monthly contribution in the traditional 401(k) and half in the Roth.
Here’s the difference. A traditional 401(k) is tax-deferred, which means you don’t pay federal taxes on the money that goes into the account. But you must pay the taxes on your account once you begin withdrawals.
When you contribute to a Roth 401(k) the money is taxed before it goes in the account. That means that not only do you not have to pay taxes when you make withdrawals, but the money grows in the account tax free.
Let’s use that $900,000 we talked about in the compound interest calculator as an example. When you reach 65 and begin withdrawals from a traditional IRA, depending on your tax bracket you may lose a third or more of that cash to taxes. If it was in a Roth, you get to keep the entire $900,000.
If you can’t afford to contribute to your company’s 401(k) because of crippling student loan debt, there’s still good news courtesy of President Joe Biden. But you must still sign up for the plan.
The Secure Act 2.0, signed into law by President Biden late last year, contained a provision that did not get a lot of press coverage. Here’s how it works: Say you are paying $400 a month to repay student loans. Under the provisions of the new law, your employer can legally consider that $400 payment as a contribution to your 401(k) even though the money is going to your student loan. That makes you eligible for the employer match. So, if your employer matches your contributions dollar for dollar up to the first 4 percent of your salary, you are eligible for that match even though technically you are not contributing money into your retirement account.
For those who have been saving in a 401(k) or 403(b) account for years, you might consider what they call a Roth conversion – convert your traditional 401(k) or 403(b) into a Roth. It might be as simple as filling out some paperwork in a 401(k). However, there are pluses and minus to this move.
As I said before, when you begin to withdraw your money from the Roth 401(k) it will be tax free. You have already paid taxes on your contributions, and the money grows in the account tax-free.
Minus. If you convert your traditional 401(k) to a Roth, you must pay the taxes now on the traditional 401(k). Many people don’t have the cash outside of their accounts to make those tax payments.
Also, the money you are rolling over will count as taxable income for that year. That may, in fact, push you into a higher income tax bracket.
As always, I recommend that you consult a financial planner or a tax advisor, or both, to help you with complicated money decisions.
Rodney A. Brooks is a Texas Metro News Columnist and Senior Fellow at Prosperity Now. The author of Fixing the Racial Wealth Gap: Racism and discrimination put us here, but this is how we can save future generations, he has written for USA TODAY, The Washington Post and National Geographic.