dmertz
Level 15
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Deductions & credits

Putting money into a traditional 401(k) as suggested by your financial planner defers taxable income to the future, it doesn't eliminate the taxable income.  That income will eventually be taxable when taken out of the traditional 401(k).  Gains in the 401(k) will be taxable as ordinary income whereas if that money is invested in capital investments outside of a retirement account the gains can be taxable at lower long-term capital gains rates.  Financial planners often suggest deferral of income because the short-term reduction in tax liability is an easy sell, but that isn't always the best long-term strategy.

 

If your income this year puts some of your income in a higher tax bracket than you normally see or makes you ineligible for some amount of certain tax credits, deferring some income with increased 401(k) contributions could make sense.  You need to do a simulated tax return to see what your marginal tax rate is.  However, if you are concerned about having penalty-free access to this money before age 59½, increasing traditional 401(k) contributions might not be the best approach.  If your modified AGI for the purpose permits, you might consider contributing some amount to a Roth IRA.  There is no deduction (no deferral of income) for contributing to a Roth IRA but Roth IRA contributions can be taken out at any time without tax or penalty and gains in the Roth IRA will be tax free once you have met the age 59½ and 5-year qualification requirements.

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