Using Your 401k to Reduce Taxable Income

As you file your taxes, you’re probably thinking about ways to reduce your taxable income. Did you know that there are a lot of strategies you can use with your retirement funds, like your IRA and 401(k), to reduce your taxable income? Save for the future and save in taxes today – that’s a win-win situation.

We’re early in 2018, and there’s still time to make some retirement maneuvers to lower your 2017 tax liability (as well as steps you can take to reduce your tax liability next year):

Make an IRA contribution by April 17, 2018.

You can make a contribution to a traditional IRA, and shield $5,500 from taxes for 2017, or $6,500 if you’re 50 or older. You can make a partial or fully deductible contribution even if you are covered by an employer retirement plan, subject to certain income limits. You can make the contribution right up until the tax filing deadline, which is April 17, 2018.  Just make sure your plan provider knows that you want your contribution to be for 2017.

It’s important to remember that only contributions to a traditional IRA can be used to reduce your current taxable income. Contributions made to a Roth IRA are not tax-deductible, and will therefore not reduce your taxable income or tax liability.

Start funding an IRA contribution for 2018 now.

If you miss the contribution deadline for the 2017 tax filing season, or if you don’t need to make one, you can still begin to plan now to make a tax-deductible contribution for 2018.

The advantage of beginning to make contributions for the current year is that you can spread your contributions over the full year, rather than making the whole contribution just before filing your taxes next year. For example, if you plan to contribute $5,500 for 2018, you can spread the payments out over 12 months, which would enable you to contribute $458 per month. That will be a lot easier and less painful than having to come up with thousands of dollars just before next year’s filing deadline in April.

Increase your contributions to your employer plan.

While you can’t make contributions in the current year to reduce your taxable income for 2017, you can begin increasing those contributions to lower your 2018 income.

If your 2017 tax return shows that you owe a significant amount of money, and you want to reduce that liability for next year, you can increase your contributions right now, so that they will gradually lower your taxable income for the rest of the year. That will give you a lower taxable income, without having to come out of pocket with thousands of dollars for a single contribution.

Take a 401(k) loan rather than a distribution.

You probably know that withdrawing money from a retirement plan before you turn age 59 1/2 is expensive. Not only do you have to pay regular income tax on the amount withdrawn (plus state income tax if your state has a tax), but you also have to pay a 10% early withdrawal penalty. But despite the high tax costs of making early withdrawals from a retirement plan, unfortunately events do occur, and people take early withdrawals all the time.

But rather than taking a hardship withdrawal from your 401(k) plan, or liquidating IRA funds, consider taking a 401(k) loan instead. The IRS allows you to borrow up to 50% of the vested value of your 401(k), up to $50,000. If your employer permits 401(k) loans, you can use the loan proceeds – rather than an outright withdrawal – to provide you with the cash that you need. Unlike retirement plan withdrawals, 401(k) loan proceeds are not taxable. It’s a way to access the funds in your plan early without incurring taxes that could take 30% or 40% or more of the amount of the withdrawal.

Saving for retirement is extremely important and the money you put away now will pay off huge when you retire.

*The dates in this article have been updated since originally published on April 4, 2017.