Getty Images/Vetta As you prepare to wade through this year’s mountain of paperwork to file your 2013 taxes, you might want to start looking into ways to cut your 2014 tax bill at this time next year.
You may well have options that could cut thousands of dollars off your 2014 tax bill — maybe even $4,000 or more. Better yet, not only could you cut your bill by that much next year, you could get those tax savings to compound for you in a tax-advantaged way for the rest of your career.
So what’s the trick? It’s simple: Contribute to your traditional 401(k), 403(b), TSP, or other qualified employer-sponsored traditional retirement plan.
How it Works
Every dollar you contribute to a 401(k) or similar plan cuts a dollar off the amount of your income that’s exposed to federal income tax. In addition, while your money is in the plan, the profits you make are tax deferred. You can collect dividends and take capital gains within the plan without worrying about immediate taxes. In fact, unless you’re investing in a way that generates something called Unrelated Business Taxable Income , you won’t get taxed on the money at all until you withdraw it from the plan.
The table below shows the federal income tax savings you’d see by contributing the maximum allowed to a typical 401(k) or similar plan in 2014. If you’re under age 50, you can contribute $17,500 in 2014, while those 50 and older are allowed to make catch-up contributions that raise their limit to $23,000. (Note that your contribution may be further limited if you’re considered a highly compensated employee and your plan fails the IRS’ “top heavy” tests.)
Tax BracketUnder Age 50
($17,500 max)Age 50+
($23,000 max)10%$1,750$2,30015%$2,625$3,45025%$4,375$5,75028%$4,900$6,44033%$5,775$7,59035%$6,125$8,05039.6%$6,930$9,108Tax bracket data from Forbes. Contribution limits from about.com. Calculation by author.
In addition to the savings at a federal level, you may see savings in your state income taxes, too. If you’re in the 25 percent tax bracket or above, your tax savings can easily exceed $4,000. Those tax savings reduce the out-of-pocket impact of your contributions and make it that much easier for you to sock away money for your retirement.
Your Money Working for You
And while the tax breaks associated with putting money in your 401(k) are great, when all is said and done, the bigger benefit comes to you in the long run, via years of tax-deferred growth. That benefit can easily add up to more than the tax deduction you gained from your initial contribution. And the money in your 401(k) will likely provide the major portion of what you’ll have available to spend during your retirement.
So if your employer offers you a 401(k) or similar plan, now’s a great time to get signed up for it and start contributing. And if you’re already signed up, it’s time to consider contributing more — as much more as you can. Whether you’re looking forward to saving money on your 2014 taxes or to enjoying your golden years, you’ll be glad you did.
Chuck Saletta is a Motley Fool contributing writer. Try any of our newsletter services free for 30 days.