Are 401(k) contributions exempt from state tax? Sometimes they are. And sometimes they are not. It depends on the kind of contributions they are. If they are pre-tax contributions, you can exclude them from your taxable income. But if they are not, you can’t.
Therefore, you need to learn the basic rules regarding your 401(k) contributions and the tax exemption policies within Form W-4 to understand how tax withholdings work.
Are 401(k) Contributions Exempt From State Tax?
The IRS permits what is known as elective deferrals. These are employer contributions to specified retirement plans, which may be excluded from your taxable income. But you must authorize your employer to contribute these funds to the 401(k) plan.
However, when you begin to withdraw the principal and earnings of your investments, you may be expected to pay taxes on them.
Pre-Tax vs. After-Tax 401(k) Contributions
Typically, the 401(k) plan has both the pre-tax and after-tax (Roth) options for eligible participants. If you choose to contribute with your pre-tax earnings, your taxable income will reduce since a portion of your income will be withheld for that purpose. On the other hand, Roth contributions are subject to taxes upfront, and won’t reduce your federal taxable income.
However, your employer can also match some of your contributions. And that means both you and your employer can claim your respective contributions as deductions on your federal tax returns.
It is also worth noting that pre-tax 401(k) contributions are also exempt from state taxes.
Elective 401(k) Deferrals
The elective deferral for safe harbor plans and traditional 401(k) plans is $19,500 for the tax years 2020 and 2021. In 2022, you can contribute up to $20,500. However, for a SIMPLE 401(k), the limit is $13,500 for 2020 and 2021 and $14,000 for the tax year 2022.
There is also a catch-up limit of $6,500 for those 50 years and older for the tax years 2020-2022.
Tax Exemption in W-4 Details vs. 401(k) Contributions
The IRS Form W-4 is known as the employee withholding certificate for a good reason. It is the form that employees fill to instruct their employers to withhold the correct amount of federal income taxes.
To determine what that amount will be, your employers need to know your filing status, what you earn and the deductions you will be making to reduce your taxable income. Deductible IRA contributions belong to this category.
Tax Exemptions on W-4
You could also claim a tax exemption on Form W-4. But that will only be valid if you have no federal tax liability or your income is below the filing threshold for your chosen filing status.
When you opt for a tax exemption, none of your income will be withheld. However, you will likely owe taxes at some point.
Read More: Claiming Dependents for Your Taxes
401(k) Contribution Deductions
Deducting your pre-tax 401(k) contributions ends up reducing your federal taxable income, which also lowers the taxes you pay for Social Security and Medicare. And your employer will work with what remains after your pre-tax 401(k) contributions are deducted to determine the tax withholdings for other taxes.
For example, if you opt for the maximum elective deferral for a traditional 401(k) plan, your taxable income will reduce by $19,500 or $26,000 if you are over 50.
Effects on Take-Home Pay
You may end up with more take-home income if you deduct your pre-tax 401(k) contributions. However, it would probably not be as much as you would if you claimed the tax exemption on Form W-4 because some of those funds will be going straight into your 401(k) account.
Remember though, that 401(k) Roth contributions are made using after-tax dollars. For that reason, you will not enjoy a higher take-home pay if you deduct them from your income since it would have already been withheld to pay for the taxes.
The basic rule of thumb is, if you want to enjoy a higher take-home pay, you should contribute towards 401(k) with pre-tax earnings or opt for the tax exemption status so the minimum amount of federal income is withheld. But you may end up owing money to the IRS if you have other sources of income or did not claim your deductions correctly. In addition, you may have to pay penalties with interest that will accrue until you pay off your tax balance.
However, if you want to ensure you don’t owe the IRS taxes and prefer to get a refund, you should avoid the tax exemption status unless you qualify for it. Also, you can claim extra taxes you want to be withheld. But it is still an excellent idea to make your 401(k) contributions, itemize and claim all the available tax deductions and credits you qualify for to reduce your taxable income as much as possible.
- Corporate Finance Institute: Elective-Deferral Contribution
- IRS.Gov: 401(k) Plan Overview
- IRS.Gov: Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits
- IRS.Gov: 401(k) Plan Fix-It Guide - Elective deferrals weren't limited to the amounts under IRC Section 402(g) for the calendar year and excesses weren't distributed
- IRS.Gov: Tax Withholding and Estimated Tax For use in 2021
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