To minimize your taxes, you can reduce your income, increase your deductions and claim tax credits. You can significantly reduce your taxable income by participating in a 401(k) plan, which derives its name from the section number and paragraph -- section 401, paragraph (k) -- in the Internal Revenue Code. It is a contributory setup that diverts pretax money to an account that will fund your future retirement.
Saving for Retirement
A 401(k) plan is a retirement savings strategy in which your employer deducts your contribution from your paycheck and sends it to the investment company that's managing your account. It's a defined contribution plan -- the amount you contribute is defined either by yourself or your employer -- although the investment company decides contribution limits, subject to Internal Revenue Service guidelines. Although no law requires it, your employer may proportionately match your contribution as an added incentive.
Adjusted Gross Income
Your taxes are based on your adjusted gross income, or AGI, which is your total earnings from all sources minus a few specific deductions, such as student loan interest, tuition, certain health-care costs and moving expenses. When you file your taxes, the AGI will determine your tax rate and the various tax credits you may be eligible for.
Deducting 401(k) Contributions
Making contributions to a 401(k) retirement plan reduces your wages and hence your AGI. Typically, your contribution is deducted every pay period from your salary or wages before taxes are calculated; the deduction isn't taken on the tax form itself. At the end of the year, your taxable income is lower, and thus you'll pay less income tax. You can increase your pretax contributions to reduce your AGI, subject to your 401(k) plan's limits. Contributions are limited to a maximum annual amount of $17,500.
If you're self-employed or an independent contractor, you can set up a 401(k) plan to which you make regular contributions. In most cases you'll get a Form 1099 from each of the entities that paid you in the tax year, which details how much you were paid. These 1099s will constitute your annual income. Come tax time, you'll take your deductions on line 28 of IRS Form 1040 for any contributions you made to the 401(k). This will lower your AGI and hence your tax bill.
- Comstock Images/Stockbyte/Getty Images