Tax Exemption W4 vs. 401(k) Contributions

by Cynthia Gaffney ; Updated September 07, 2018

Perhaps you need extra take-home pay in your paycheck each month or maybe you have a little surplus income and want to increase your retirement savings. You can accomplish either or both of these objectives by tinkering with your employer-sponsored 401(k) contribution amounts and your IRS Form W-4 withholding allowances. You can change the number of withholding allowances, such as if you want to increase withholding levels, on your W-4 form as often as you'd like, which directly affects how much your employer withholds from your pay to cover your tax bill. If you start or increase 401(k) contributions, that reduces your paycheck, with the benefit of cutting your taxes.

Finding IRS Form W-4

You've probably seen Form W-4 before; you fill it out any time you start a new job as an employee and receive a paycheck from a company. On the form, you declare how many allowances to have withheld from your pay to cover your income tax bill. The more allowances you claim, the less money is withheld. Employees typically claim more allowances if they have many dependents and need to take home more income each month. Claiming the least number of allowances, such as one or zero, withholds the maximum amount of money from your paycheck, guaranteeing that you'll get a refund at tax time. You can work with your tax professional to calculate the right number of withholding allowances to claim in order to break even at tax time. In other words, you won't owe the IRS, but you won't get a refund either.

Looking at Tax-Deferred 401(k) Plans

A 401(k) account, while not claiming 401k tax exempt status, helps workers put away money for retirement without having it taxed upfront, so the more money contributed to a 401(k) plan, the lower the remaining pay on which you have to pay taxes. Not only do you pay lower income taxes because you'll have a smaller adjusted gross income to report on your tax return, but you'll pay less in payroll taxes from each paycheck. This includes Medicare, Social Security and federal, state and city tax withholdings. Each of these are assessed as a certain percentage of your pay, so when earnings go down, these amounts go down as well. While you might reduce your pay by $150 each month for 401(k) contributions, you'll also lower your other taxes a bit. Since these two actions offset each other, you'll see your overall net pay decrease by less than your $150 contribution.

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Obtaining Additional Information for Withholding

After increasing or decreasing the money withheld from your pay for 401(k) contributions, check that the number of allowances on your W-4 form still withhold the right amount of money to hit your goal, whether that's to owe, get a refund or break even at tax time. Contributing to a 401(k) plan lowers your income taxes, payroll taxes and helps you save for retirement. Changing your withholding allowances (if you decide to increase withholding, for example, has no tax benefit at all. You are merely changing the timing of the receipt of your pay; either you get the funds each month on your paycheck or you get a tax refund later.

Reporting Considerations

If you choose a high number of withholding allowances because you want to maximize the amount of pay you receive each pay period, you run the risk of owing money at tax time and not being able to come up with extra funds to pay the bill. If you file your tax return without paying what you owe, you'll receive a failure-to-pay penalty from the IRS, and the amount due will accrue interest until you pay off the balance.

About the Author

Cynthia Gaffney has spent over 20 years in finance with experience in valuation, corporate financial planning, mergers & acquisitions consulting and small business ownership. She has worked as a financial writer for online finance publications since 2011, including eHow Money, The Motley Fool, and Sapling.com. She has also edited for several online finance publications, including The Balance, Opposing Views:Money, Synonym:Money, and Zacks.com. A Southern California native, Cynthia received her Bachelor of Science degree in finance and business economics from USC.

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