Financial Q&A: Readers' money questions answered
How to grasp tax benefits from retirement savings.
Q: How does a 401(k) help lower my taxes? I was told that my employer does not withhold enough taxes for me, and so I always find I owe money to the IRS in April.
M.J., via e-mail
A: To encourage people to save for retirement, the federal government defers income taxes owed on contributions to employer-sponsored 401(k) or 403(b) plans. It accomplishes this by pretending that you didn't earn that money. This arrangement lasts until you withdraw the funds. At that point, the government will tax that money as income.
For now, however, Joshua P. Roberson, an enrolled tax agent in Upper Marlboro, Md., creates a scenario showing how you'll save on taxes by contributing to a 401(k).
Let's say your gross wages are $1,000 and you don't belong to a 401(k). In this case, 10 percent of your pay is withheld for federal taxes and 5 percent for state taxes. That's $150. If you contribute $150 to a 401(k), though, the government sees that you've earned just $850 and will base its withholding on that amount. Using the same rates, the federal and state tax bite is now $127.50, for a savings of $22.50.
That's how you lower your taxes. And set aside some savings, to boot.
As to insufficient withholding, your employer is taking out the amount you tell it to, based on the W-4 form you filed when you first started your job. You can easily resolve any deficiency by going to your human resources department and boosting the amount of money you want withheld from your paycheck. Penalties and interest charges await those who don't handle their withholding properly, so you may want to do this sooner than later.