The Internal Revenue Service allows you contribute to your 401(k) on a pretax basis. So while increasing your 401(k) does affect your take-home pay, it's not a dollar-for-dollar decrease, since your taxable income goes down due to the higher contribution. This means you pay less in taxes. You may also get extra money if your employer matches your contributions. Usually the more you put in, the more your employer also contributes on your behalf, up to a certain point.
When you make your 401(k) contribution, you do so on a pre-tax basis, meaning the amount comes out of your gross pay. For example, if you make $2,000 a month in gross pay and currently contribute $200 a month to your 401(k), you’re only taxed on $1,800. The $200 is not taxed until it is taken out of the 401(k). If you up your contribution to $300, the part of your pay subject to income taxes drops to $1,700.
Assuming you are in the 15 percent tax bracket, if your pay after your 10 percent contribution is $1,800 a month and you claim no tax allowances, you'll have about $270 a month withheld from your check for federal taxes. By increasing your contribution to $300, you'll only pay around $255 per month for federal taxes. You've added $100 to your 401(k) and you're now paying $15 less in taxes per check. Your increased contribution of $100 has really only affected your take-home pay by $85.
Making before-tax contributions to a 401(k) does not reduce the amount taken out of your check for FICA -- Social Security and Medicare taxes. Your part of FICA remains at 7.65 percent -- as of publication -- of your gross pay, or the $2,000, you earned before making your 401(k) contribution. The 7.65 percent includes a 6.2 percent withholding for Social Security taxes and a 1.45 percent withholding for Medicare taxes.
You'll also benefit from an increased contribution if your employer matches what you put in the 401(k). If you increase your contribution, the employer will as well. If your employer matches you dollar-for-dollar, your 401(k) increases by $200 for every $100 you add -- $100 from you and $100 from your employer. If your employer offers a limited match, you should try to up your contribution to that limit. In other words, if the employer match the first 10 percent you contribute, you should work to get your contribution to that level so you can receive the full match from your employer. It's essentially free money.
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