I recently spoke with a financial planner. I was explaining how I sold my parents estate last year and wanted to invest the money. She recommended that since I had not maxed out my 401k contributions for the tear, that I should increase my payroll deductions to max out my pretax contributions and that I supplement the shortage in my paycheck with the funds from the estate sale proceeds. She indicated it would lower my taxes at the end of the year by doing this.
I am hesitant to do this because my mind feels like I am eating cash in the bank (despite realizing what she stated sort of makes sense).
I wanted an opinion on this approach.
just for reference sense last year we missed the ability to be able to deduct college expenses because we made too much income but we missed the cut off the irs sets by about $10k. I’m wondering if doing this would make any difference in lowering my taxes to be able to even qualify in taking the college expense deduction. Is there any way for me to calculate what benefit I would have in doing this?
thanks in advance
contributions to a 401k will lower your adjusted gross income and reduce your taxes. The tradeoff is that you generally can not withdraw the money until you are over 59.5 without a 10% penalty (there are a few exceptions to that rule, but let's not go there).
your adjusted gross income (line 11) needs to be below $180,000 to be eligible for the college tax credits. And as long as the qualified educational expenses exceed any scholarships by at least $4000, you should be eligble for a $2500 tax credit (Look at form 1098-T - box 1 and box 5)
everyone's tax situation is different so it is hard to provide an opinion.
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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