Will increasing my 401(k) contributions impact the percent at which my large, lump-sum bonus is taxed?
I work at a company that gives two lump-sum bonuses a year. I expect the bonuses to be abnormally large this year. Would it benefit me to increase my 401(k) contribution before the bonuses are distributed? Would increasing my 401(k) contribution even impact the percent at which my bonus is taxed?
It certainly is possible to lower your tax bracket by contributing more of your bonus or earned income into a traditional 401(k), however most of my clients confuse the amount being withheld from their paycheck or bonus check with how much they are truly being taxed. Most people believe they are being taxed more for an annual or semi-annual bonus however that is not the case. The important thing to remember is that withholding on your paycheck is a estimate of the taxes your will owe, not the actual amount. The following information will provide you with a framework for the taxes being withheld by your employer from your bonus.
Bonuses are considered supplemental income by the IRS, which means that they could be withheld differently than your regular salary. The IRS suggestion is a flat withholding of 22% from bonuses, so many employers follow that method. However, some employers also use an aggregate method in which your whole bonus is added to your regular paycheck, and the combined amount is withheld at the normal income rate, as though that amount is representative of what you make every paycheck, this could be higher or lower than 22% but for most people it creates a much higher withholding percentage from their regular paycheck. Keep in mind that at the end of the year your regular income and bonus income is all added together and reported as part of your gross income for the year.
So back to your 401(k) question. If your goal is to lower the total amount you pay in taxes and perhaps your overall tax bracket then increasing your 401(k) contribution may help, however if you're looking to lower the taxes being withheld for your bonus check then it probably won't make a large difference.
The contributions you make into a traditional 401(k) plan (not a Roth 401k) are tax deductible, which means the money contributed is deposited into your 401(k) from your paycheck prior to you receiving it and taxes withheld. If you increase your traditional 401(k) contribution prior to receiving your bonus then you will have a larger percentage going into your 401(k) and therefore you will receive less income in total for the year. You'll want to make sure your employer allows 401(k) contributions from bonuses, some do not. By having less earned income you could potentially lower your tax bracket as well, however this will depend on your reported income, deductions and tax credits for the year. You can reference the IRS's 2018 Federal Tax Rate for more information.
While I hope this information is helpful you should always consult a tax professional to understand your individual circumstances before making any important decisions. Good Luck.
Increasing before your bonus won't have much of an affect on what your net bonused dollars will be. However when you go to file your taxes at the end of the year it will all be taken into account. They'll basically look at what you made, minus what you deferred and then that will spit out your taxable income. If you over or under withheld will then determine if you are eligible for a refund or not at the end of the year. Certainly never a bad thing to defer more money into 401(k) accounts and lower your taxable income.
The United States income tax generally operates at marginal brackets, with your income taxed at different rates as each bracket "fills up". Only the income in the last bracket is taxed at that highest marginal tax rate.
Contributing to a tax deferred retirement savings account, like a traditional 401(k), excludes the amount of the contributions from the calculation for total income in that year for tax purposes. So in the case of your question, increasing your 401(k) contribution, holding all else equal, would lower your taxable income for the year. Your bonus may be large enough to push some of your income into a higher marginal bracket, but whatever you are able to put into tax deferred accounts will lower the total amount of income subject to income tax in that year.
As always, each person's situation may differ from the typical or general, so it is advisable to seek out a professional tax opinion on your specific case.
If you don't need the funds to live on, increasing your 401k contribution seems very prudent. All funds that go into the 401k are pretax unless you elect otherwise. Your tax bill will be less by contributing more.
Making contributions to a 401(k) can only reduce your taxes, not increase it, because those contributions are subtracted from your income when computing your marginal tax rate. There is an annual maximum so that contributions above that level don't further decrease your income but can later be rolled into a Roth IRA since they weren't used as a tax deduction.