Tax Exemption W4 vs. 401(k) Contributions

Without your W4, it is difficult for your employer to withhold the correct amount of federal income tax from your paychecks. Because this tax is mandatory, unless you qualify for an exemption, the Internal Revenue Service requires employers to withhold at single filing status with zero exemptions or allowances, if an employee fails to fill out a W4; this is the highest tax bracket.

When filling out the W4, go through lines A to G and claim the personal exemptions you are entitled to. On the withholding allowance certificate portion of the form, put your filing status and total number of exemptions/allowances. Your employer uses your W4 data and the IRS withholding tax tables to figure out the exact amount of federal income tax to withhold from each of your paychecks.

Retirement plans vary by employer. In many cases, employers offer traditional 401(k) and Roth 401(k) options. The former allows you to make contributions in pretax dollars, and the latter in post-tax dollars. To set up a 401(k) plan, your employer must comply with four basic rules: establish a written plan, set up a trust fund for the plan’s assets, implement a record-keeping system, and provide plan data to participants. The IRS regulates the maximum amount that participants may contribute to a 401(k) plan each year. You can opt for a flat or percentage amount of your earnings to go toward the plan.

Each exemption you claim on your W4, gives an amount that lowers your taxable income; therefore, the more exemptions you claim, the less federal income tax you pay. Likewise, the fewer allowances you claim, the more tax you pay. For example, as a married individual, you may claim your spouse and all of your dependents on the form; make sure your spouse does not claim those same dependents on his W4. Being married also puts you in a lower tax bracket than being single. Therefore, if you have many exemptions and claim as married, you pay less tax than someone who earns the same salary or wages as you but claims fewer exemptions and single filing status.

Pretax 401(k) contributions are made after federal income tax is withheld from your gross income; this process increases your take-home pay. Specifically, your employer subtracts the 401(k) amount from your earnings, then withholds federal income tax. Because the contribution is taken out prior to federal income tax, your taxable wages are reduced and your take-home pay is increased. In the case of a Roth 401(k), which is post-tax, your take-home pay is not increased, because the contribution is made after federal income tax is withheld from your paychecks. This process does not lower your taxable income.

Traditional 401(k) contributions are not subject to federal income tax withholding, but when you withdraw from the plan, the money is subject to taxation. Roth 401(k) withdrawal is not subject to taxation because your employer already withheld the tax from your paychecks in post-tax dollars. Note that a W4 relates only to federal income tax withholding. Regardless of whether your 401(k) contributions are made in pretax or post-tax dollars, both are subject to Social Security and Medicare tax withholding.