How Taxes, 401(k) Plans And IRAs Work

Taxes, 401(k) plans and individual retirement accounts, or IRAs, are complicated. If you can master the fundamentals of your personal taxes and understand your retirement savings options, you’ll be able to make informed decisions about your future.

The IRS estimates the average taxpayer spends 12 hours working on their taxes and pays an average of $230 to get their paperwork filed.

“Your tax return is in no way that simple,” said Mark Steber, chief tax information officer at Jackson Hewitt Tax Service. “I don’t care who you are or what economic situation you’re in — high, medium, low, no income or unemployed.”

However, tax experts say all those IRS tax return forms and schedules are actually designed to help people save money.

“If you have knowledge about how it works, you can utilize the tax code to benefit you more in the long run,” explained Sheneya Wilson, founder of Fola Financial in New York. “However, most people don’t have that knowledge, and I think that is what creates this fear of the IRS and paying taxes, when essentially the tax code is not there to harm anyone.”

Retirement plans can impact your annual taxes. Until the 1980s, most Americans planned for retirement through pensions. They were defined-benefit plans, in which employers saved on workers’ behalf and calculated employees’ retirement benefits based on their years of service and final salary. That changed when Congress passed a new tax code in the Revenue Act of 1978. The act included a new provision in the Internal Revenue Code, Section 401(k), which gave employees a tax-advantaged way to defer compensation from bonuses or stock options.

401(k) and other defined-contribution plans like it quickly replaced traditional pension plans. Unlike traditional pensions, 401(k) plans are defined-contribution plans. Employers create a retirement plan in which their employees can contribute a portion of their wages on a pretax basis, up to an amount determined by the IRS.

From 1980 through 2008, participation in pension plans fell from 38% to 20% of the country’s workforce, while employees covered by defined-contribution plans jumped from 8% to 31%, according to the U.S. Bureau of Labor Statistics.

In 2020, there were about 600,000 401(k) plans, with approximately 60 million Americans participating in them. The 401(k) continues to be one of the most popular retirement savings options for U.S. workers.

When people think of retirement savings, in addition to 401(k) plans, IRAs likely come to mind. The key difference is that employers offer 401(k) plans whereas individuals open IRAs. There are pros and cons to both, but if you understand how to contribute and invest those contributions you can maximize your return ahead of your retirement.

Watch the video above to learn about taxes, IRAs and 401(k) plans.

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How Taxes, 401(k) Plans And IRAs Work