401(k) Taxes in 2017: What You Need to Know

By Dan Caplinger Markets Fool.com

For most taxpayers, 401(k) accounts offer the best opportunity to save for retirement. With matching contributions from many employers, high contribution limits, and long-term tax deferral, 401(k) plans have become the foundation for many Americans' retirement planning. In order to use 401(k)s effectively, though, it's essential to know details about how they work and what benefits you can get from using them.

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What are 401(k) contribution limits in 2017?

Few retirement plans offer the ability to save more in a tax-favored manner than 401(k) plans, and in particular, 401(k) contribution limits dramatically exceed what you can set aside in an IRA. For both 2016 and 2017, those who are under 50 years old can save $18,000 in a 401(k) account, while those 50 or older can set aside up to $24,000. However, if you earn less than those amounts, then you're limited to the amount of income you earn. You're not allowed to take savings from other sources and use it to contribute to a 401(k).

Image source: Getty Images.

What are the tax benefits of 401(k)s?

Different benefits apply to different types of 401(k) plans. With traditional 401(k)s, you can reduce your taxable income by contributing more to the retirement account, reducing your current-year tax bill. With a Roth 401(k), you don't get a reduction in taxable income now, but you can treat distributions later on as tax-free, never paying taxes on the appreciation or income earned in the Roth during your career.

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Will having a 401(k) plan stop me from using an IRA?

IRAs are generally available to those who don't have access to retirement plans at work. However, those who are covered by a 401(k) have some restrictions on their ability to take full advantage of IRAs.

Having a 401(k) has no impact on your ability to contribute to a Roth IRA. Income limits exist that can prevent you from making a Roth contribution, but those limits aren't affected by whether or not you have access to a 401(k) plan.

However, if you want to open a traditional IRA to get an upfront deduction but you also have access to your own 401(k) account, you might be thwarted by provisions that impose income limits on the deductibility of IRA contributions. The following chart shows the critical adjusted gross income numbers for 2017.

If You File As

Then IRA Deductions Start Phasing Out When Adjusted Gross Income Reaches

And Phase Out Entirely When AGI Reaches

Single or head of household

$62,000

$72,000

Married, filing jointly or qualifying widow(er)

$99,000

$119,000

Married, filing separately

$0

$10,000

Data source: IRS.

In addition, even if you don't have a 401(k), phase-out provisions exist in cases in which your spouse does have a 401(k) plan. The income limits you see below for joint filers are higher than for 401(k)s you have yourself, and obviously, they're only applicable to married taxpayers.

If You File As

Then IRA Deductions Start Phasing Out When Adjusted Gross Income Reaches

And Phase Out Entirely When AGI Reaches

Single or head of household

N/A

N/A

Married, filing jointly or qualifying widow(er)

$186,000

$196,000

Married, filing separately

$0

$10,000

Data source: IRS. N/A = not applicable.

Can I ever take money out of a 401(k) without penalty?

Retirement accounts are meant to be used in retirement, so a 10% early withdrawal penalty usually applies when you take money out before you should. However, there are some exceptions to the rule that prevent you from having to pay the penalty.

Various types of financial hardship are a common reason for accessing 401(k) money early. The tax laws waive the penalty on distributions following a total and permanent disability, and they allow distributions to cover medical expenses of more than 7.5% to 10% of adjusted gross income depending on age. If the IRS levies the 401(k) plan, then you can make distributions without penalty, and qualified reservists can also take active-duty distributions.

However, there are also some more general withdrawal provisions. For instance, if you decide to take a series of substantially equal periodic payments over your life expectancy after you stop working for your employer, then those distributions aren't subject to penalty.

Just remember that regardless of whether the penalty applies, you'll still have to pay income tax on amounts withdrawn from traditional 401(k) accounts.

Be smart about your 401(k)

A 401(k) account is great for retirement saving, but it comes with key provisions you must remember. Doing so will ensure that you take maximum advantage of 401(k)s in your retirement planning.

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