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Tax Exemption W4 vs. 401(k) Contributions

Original post by Jonathan Langsdorf of Demand Media

Changing exemptions or your 401k contributions affect your results at tax filing time.

Changing the number of claimed exemptions on your W4 and making or increasing your 401k contributions both affect your take home pay, but in different directions. Changing one or both of these items also affect the amount of income taxes you must pay or the size of your tax return.

W4 Exemptions

The number of exemptions you claim on a W4 affects the amount of income tax your employer will withhold from your salary or wages. Increasing the number of exemptions you claim will reduce the amount of taxes withheld and increase your take home pay. If you usually receive a large income tax return check, you can increase your number of exemptions and increase your take home pay and reduce the size of your tax return check. If you have to send money to the Internal Revenue Service each year, reduce your number of exemptions to have more tax withheld from each paycheck.

401k Plans

A 401k is a retirement savings plan established by your employer. You are allowed to defer a portion of your wages into the plan before taxes. The assets in the plan then grow tax deferred. The benefit of making 401k contributions before tax is the amount you contribute reduces your taxable income for the year, and therefore your tax bill, too. Making 401k contributions provides dual benefits of lowering your current income taxes and building savings for retirement.

Reducing Taxes Due

If, when filing your income tax return, you have been required to send more money to the IRS, both changing your exemptions or increasing your 401k contribution can reduce your the amount of taxes you have to pay at tax filing time. Decreasing your exemptions will increase the amount of taxes withheld from your check. A higher level of withholding spreads your annual tax bill over each pay check, rather than making a big payment in April. Increasing your 401k contribution reduces your taxable income, reducing the taxes owed for the year.

Effects

Decreasing your number of exemptions will result in a smaller net reduction in your take-home pay compared to increasing your 401k contribution. Increasing your 401k deduction may actually decrease the amount of tax withholding unless you also make adjustments to your number of exemptions. However, 401k salary deductions remain your money and become part of your wealth building plan. Decreasing exemptions just reduces the pain at tax filing time. You are still paying the same amount of tax for the year.

                   

References

About the Author

Jonathan Langsdorf has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Langsdorf has a bachelor's degree in mathematics from the U.S. Air Force Academy.

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