Few tax breaks are bigger than what's available to those who have 401(k) plan accounts at work. In addition to the tax deferral that they offer, many employees get employer matches for the money they put into their 401(k) accounts. High contribution limits also let savers set aside massive amounts for future needs.
Making the most of 401(k)s is essential to cut your tax bill. Here are some of the most important things you need to know about 401(k)s and how they'll affect your taxes in 2018.
Why 401(k)s can help you save for retirement
401(k) plans allow you to get a variety of different tax benefits. Most conventional 401(k)s let you defer tax on your contributions, effectively getting a deduction by reducing the amount of income you have to report on your tax return. Roth 401(k) accounts don't offer an upfront tax break in the form of reducing your taxable income, but they let you put after-tax money into an account that generates income that will eventually be tax-free as long as you meet the requirements for later distributions.
The contribution limits for 401(k)s are among the highest for tax-favored retirement accounts. In 2018, you can set aside up to $18,500 if you're younger than 50 years old, while those who are 50 or older get an additional $6,000 catch-up contribution, bringing the total to $24,500. In no circumstances, though, can you put more money into a 401(k) than you actually earn from the employment in question.
How 401(k)s can work alongside IRAs
Many people use IRAs as a retirement savings vehicle. If you -- or a spouse, if you're married -- are covered by a 401(k) at work, then the 401(k) can have a negative impact on your IRA deductions.
In particular, traditional IRA deductions are subject to set income limits. For those who have their own 401(k) plan accounts, here are the limits for 2018:
DATA SOURCE: IRS.
If you don't have a 401(k) but you're married to someone who does, then the following higher limits apply:
DATA SOURCE: IRS.
By contrast, you can make Roth IRA contributions regardless of whether you have a 401(k). Income limits apply to Roth contributions, but they're the same both for those who do have a retirement plan account at work and those who don't.
Tax impacts of taking 401(k) money early
In general, if you take money out of a 401(k) before you reach retirement age, then you'll not only pay taxes on the amount you withdraw but also have to add on a 10% penalty. That reflects the policy intent of having 401(k) money saved solely for retirement purposes.
Regardless of when you take withdrawals from a traditional 401(k), you'll owe tax. But you can avoid the penalty in several different situations. Although the general retirement age for penalty purposes is 59 1/2, those who leave their jobs at age 55 or later can take withdrawals immediately without penalty. The limit for public safety employees is even lower at age 50. Other situations include large amounts of medical expenses, permanent disability, or choosing to take a preplanned series of substantially equal payments between now and when you turn 59 1/2, with a minimum requirement of five years of withdrawals.
Make the right move with your 401(k)
Retirement savers can get a lot of value from their 401(k) retirement savings plan accounts. Keep the points above in mind, and they'll help you make the most of the opportunity you'll get from participating in your employer's 401(k) plan.