Employer-sponsored 401(k) plans provide employees with a tax-friendly way to save for retirement. They also allow employers a way to fund an alternative to a traditional pension plan by matching employee 401(k) contributions. Taxes on your 401(k) contributions are deferred and won’t come due until you withdraw the money at retirement.
Taxable Income Reduced
The contributions employees make to their 401(k) plans while they are working are a tax deduction that reduces taxable income during their working years. The Internal Revenue Service sets a limit on how much you can contribute each year. As of 2012, you can contribute up to $17,000 annually to your 401(k) and subtract the contribution from your taxable income for the year. When you reach age 50, you can contribute an additional $5,500 for a limit of $22,500 annually.
How You Contribute
You make contributions to your 401(k) account by enrolling in your employer’s plan and instructing the employer to subtract a certain dollar amount or percentage from your gross pay each pay period. The employer deposits that money into your 401(k) account instead of paying it to you. The employer subtracts your 401(k) “elective” contribution from your gross pay before income taxes are withheld. Withholding of Social Security and Medicare taxes is figured on your entire gross pay.
When you receive your Form W-2 income statement for the year, the taxable wages reported in Box 1 will be net of your elective 401(k) contributions. The amount you elected to contribute from your pay will be reported in Box 12 as a subtraction from taxable income, and Box 13 will designate this sum as a retirement plan contribution. Matching contributions made by your employer won’t be reported on your W-2 and don’t count as part of your taxable income for the year.
If you have only one 401(k) plan, your plan administrator will stop elective contributions when you hit the contribution limit. But if you have 401(k) accounts with multiple employers, you could inadvertently exceed the limit. That’s because the limit applies collectively to all your 401(k) plans, not to each account individually, and a plan administrator has no way to track your contributions to other plans. If you have an excess contribution, notify the appropriate plan administrator to have the money returned to you. The excess and any earnings on it will be reported to you on Form 1099-R. Add the excess and any earnings on that money to your taxable income for the year.
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