Will contributing more to our 401k help us not owe with our tax return filing?

Believe it or not, the short answer is “no, not necessarily.”
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That’s because the reduction in taxable income from the 401k contribution also reduces the amount withheld by the payroll company. So while taxes go down as a whole, so do withholdings, which leaves the shortage intact.
 
Follow the logic here...
 
Broken down into its most simplistic form, a tax return works as follows:

1. Income is totaled
2. Adjustments (certain deductions) are applied
3. Income is further reduced by taking itemized (or standard) deductions
4. The result is taxable income
5. Tax is calculated on that taxable income
6. Tax is compared to pay withholdings, estimated tax payments, and applicable credits
7. Result determines if taxes are owed from the return filing, or if a refund is due

 
That’s...

1.   Income
2. - adjustments
3. - itemized/standard deduction
4. = Taxable income
5. Tax Liability (calculated applying prevailing tax rate(s)) to above taxable income
6. - payments made
7. = Amount owed (or Refund)

 
Example:

1.   $60,000 (Joe & Susie’s employment income)
2. -    1,500 (student loan interest adjustments)
3. -   29,200 (standard deduction)
4. =$29,300 (taxable income)
5.    $3,052 tax (applying tax rates to $29,300 taxable income)
6. - $2,100 payments (W2 withholdings)
7. =$   952 amount owed with tax return filing

 
A common myth is that if Joe & Susie just contribute to their 401k, they can fix this problem of being short at tax time.
 
However, while 401k contributions help lower the overall tax burden (#6 in the calculation), they don’t necessarily fix the problem at hand. Unless Joe & Susie adjust their actual W4 with their employer to change the portion of withholdings taken, they’ll still likely wind up short come tax filing time. It’s important to note that 401k contributions not only lower taxable income, but they’ll also lower withholdings. That’s because payroll companies withhold at certain rates based on your taxable income.
 
With this info, let’s look at another example of Joe & Susie, this time having $5,000 in 401k contributions.
 
Example with 401k Contributions:

1.    $55,000 (Joe & Susie’s employment income, after $5,000 401k contributions)
2. -     1,500 (student loan interest adjustments)
3. -   29,200 (standard deduction)
4. = $24,300 (taxable income)
5.     $2,452 tax (applying tax rates to $24,300 taxable income)
6. -    1,600 payments (W2 withholdings)
7. =    $  852 amount owed with tax return filing

 
So you can see that despite the fact Joe & Susie owed $556 in the original example and their tax dropped $500 in the 401k contribution example, Joe & Susie still owe taxes. That’s because while taxable income and taxes dropped, so did the withholdings! Remember, the 401k contributions lower the amount of income the payroll company sees, so the corresponding amounts withheld reduce as well. That is, unless the W4 is adjusted to modify the rate at which withholdings are taken.​ 

​Contact us if you have any questions! 

Updated 1/22/2024