Doubts on Tax benefits on Individual 401k contributions

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cvsvm2007
Posts: 105
Joined: Thu May 02, 2019 3:26 pm

Doubts on Tax benefits on Individual 401k contributions

Post by cvsvm2007 »

Friends,

I spent some time researching the tax benefits on Individual 401k contributions and I am unable to understand. I am confused and unable to quantify the benefits.
I have an Individual 401k account with Vanguard and I also have an Individual Roth 401k account. Can someone please point or help with the benefits on "Employee" and "Employer" contributions to my Individual 401k plan?

Apologize for asking a basic query.

Thanks
exodusNH
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Joined: Wed Jan 06, 2021 7:21 pm

Re: Doubts on Tax benefits on Individual 401k contributions

Post by exodusNH »

cvsvm2007 wrote: Tue Dec 07, 2021 7:16 pm Friends,

I spent some time researching the tax benefits on Individual 401k contributions and I am unable to understand. I am confused and unable to quantify the benefits.
I have an Individual 401k account with Vanguard and I also have an Individual Roth 401k account. Can someone please point or help with the benefits on "Employee" and "Employer" contributions to my Individual 401k plan?

Apologize for asking a basic query.

Thanks
401k plans have higher yearly limits than IRAs.

In some states, they have better legal protection from creditors.

The contribution your employer makes is free money to you.
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JoMoney
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Re: Doubts on Tax benefits on Individual 401k contributions

Post by JoMoney »

Regular (non-Roth) 401k contributions come out of your paycheck before any taxes are paid.
If your top federal tax bracket reaches say, 24% then the money going into the 401k comes out off the top of your paycheck without that 24% of federal income taxes being paid on it. If the money was paid out to you in your paycheck, it would be -24% less than what you would have otherwise got by putting it away saving it for retirement.

That tax savings is only deferred until you eventually take the money out in retirement, then you get taxed on it... but if you don't have other income (you're retired) the tax rate will be much lower, even if the income you withdraw from that 401k account reaches to that same 24% tax bracket the money would still be taxed at a lower rate because you're getting a standard deduction and then filling up the lower tax brackets bottom up.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham
mb189
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Re: Doubts on Tax benefits on Individual 401k contributions

Post by mb189 »

The majority of employers offer some kind of "match" to any amount you defer to your company's 401(k) plan. However, there are typically stipulations:
(1) There is ordinarily a cap (e.g. 50% match up to 10% of salary at my company)
(2) The employer's match may or may not vest immediately. Vesting means the money from the employer is officially yours. At my company, the employer contribution vests immediately (i.e. when that pay period completes). At my wife's company, it took 3 years for the employer contribution to vest. This only matters if you think there's a high likelihood of not being at your employer in the long haul.

So imagine you contribute $1 to your 401(k), you are in 24% federal tax rate, and your company has a 50% match. Then you (1) save $.24 on taxes for the following year (that dollar is NOT included in your AGI) and (2) you end up with $1.50 in your 401(k). You can either spend the tax benefit or save it in a taxable brokerage account. But basically you've turned $1 into $1.74 without even making any money off the investment. The flip side is that you are taxed later on the contribution and the gains.

This is why the first step in the process is maxing out your employer's 401(k) above all else (even paying off debt in many cases). Despite having to pay the tax later, the combined employer match AND tax benefits essentially amount to a guaranteed and immediate return which you really can't find anywhere else.
sailaway
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Re: Doubts on Tax benefits on Individual 401k contributions

Post by sailaway »

For an individual 401k you can defer up to the lower of your income and the annual deferral limit. You can choose between tax deferred (pay no income tax now, pay your regular income tax on withdrawals) or Roth (pay income tax now, no tax on withdrawals). See the wiki for help in choosing.

Beyond this employee deferral, you can also make a contribution as the employer. The limit for this is the lesser of 25% of profit and (annual limit minus deferral limit). These contributions will be traditional (taxed on withdrawals), but will count as a business deduction this year.
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Tamarind
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Re: Doubts on Tax benefits on Individual 401k contributions

Post by Tamarind »

cvsvm2007 wrote: Tue Dec 07, 2021 7:16 pm Friends,

I spent some time researching the tax benefits on Individual 401k contributions and I am unable to understand. I am confused and unable to quantify the benefits.
I have an Individual 401k account with Vanguard and I also have an Individual Roth 401k account. Can someone please point or help with the benefits on "Employee" and "Employer" contributions to my Individual 401k plan?

Apologize for asking a basic query.

Thanks
EmployEE contributions are like what you'd get at an employer-sponsored 401k. $20,500 next year and can go to either traditional or Roth. If you also have an employer sponsored 401k from a job where you get a W2, you may not be able to make this contribution. This has the same benefit as contributions to a "normal" 401k.

EmployER contributions are ones that you get to make AS the employer. The limit is based on a formula related to how much net income you have from your self-employed work. For many people it works out to about 20% of net income, capped at $61,000 minus your employEE contributions. This can only be a traditional contribution. Making this kind of contribution can reduce your QBI deduction.

It's very important to do correctly the math for how much you can contribute and to make the contributions in the appropriate bucket as employEE or employER.
Topic Author
cvsvm2007
Posts: 105
Joined: Thu May 02, 2019 3:26 pm

Re: Doubts on Tax benefits on Individual 401k contributions

Post by cvsvm2007 »

Thanks for all the responses. I dd my research and following is my situation:

Based on my income, I can make

An employee contribution of $19,500, plus
An employer contribution of $14,683.77

Below Age 50 and I have an Individual 401k account that has both Roth and non-Roth types.

My questions are:

Am I right, that Employee contribution reduces my taxable income and Employer contribution is tax-deductible which reduces my Business profit?

Also, Employee contribution can be applied as Roth, pre-tax, and voluntary after-tax contributions and Employer contributions can be applied only as pre-tax?

Are my above understandings right?

Thank You
nolesrule
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Joined: Thu Feb 26, 2015 9:59 am

Re: Doubts on Tax benefits on Individual 401k contributions

Post by nolesrule »

cvsvm2007 wrote: Wed Dec 08, 2021 7:26 am Thanks for all the responses. I dd my research and following is my situation:

Based on my income, I can make

An employee contribution of $19,500, plus
An employer contribution of $14,683.77

Below Age 50 and I have an Individual 401k account that has both Roth and non-Roth types.

My questions are:

Am I right, that Employee contribution reduces my taxable income and Employer contribution is tax-deductible which reduces my Business profit?

Also, Employee contribution can be applied as Roth, pre-tax, and voluntary after-tax contributions and Employer contributions can be applied only as pre-tax?

Are my above understandings right?

Thank You
Are you an S-Corp or Schedule C? It makes a difference both in how the employER contribution is calculated and also how it is deducted from income. It's a business deduction for S-Corps but both employee pre-tax and employER contributions for Schedule C self-employed go on one of the Schedules for the 1040 as an income deduction. Schedule C vs. S-Corp also makes a difference with employEE deferrals since all employEE contributions from an S-Corp must be deducted from W-2 salary.

voluntary after-tax contributions are only allowed if your Solo 401k plan supports it. Employer contributions are always pre-tax.
Last edited by nolesrule on Wed Dec 08, 2021 8:33 am, edited 1 time in total.
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JoeRetire
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Re: Doubts on Tax benefits on Individual 401k contributions

Post by JoeRetire »

cvsvm2007 wrote: Tue Dec 07, 2021 7:16 pmCan someone please point or help with the benefits on "Employee" and "Employer" contributions to my Individual 401k plan?
We all started somewhere.
This might help: https://www.thebalance.com/how-401k-plans-work-4135451
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Topic Author
cvsvm2007
Posts: 105
Joined: Thu May 02, 2019 3:26 pm

Re: Doubts on Tax benefits on Individual 401k contributions

Post by cvsvm2007 »

@nolesrule I think I am not s-corp. not sure though. This is a software programmer freelance type of job with EIN. Only one employee.


@JoeRetire Thank You
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