Tax Tips: Max Out Your 401(k)

As tax time approaches, it's time to think about ways to lower your obligation to Uncle Sam.

In the first installment of our five-part series, we walked you through adjusting your withholding.

Now it's time to think about maximizing your contributions to tax-advantaged retirement plans.

For many workers, the place to start is with your company's 401(k) plan.

"It sounds basic, but only about two-thirds of eligible employees actually participate in an employer's 401(k)," says Tom Scanlon, a CPA and certified financial planner at Borgida & Company, P.C., in Manchester, Conn.

The benefit here -- besides the obvious value of socking money away for retirement -- is that pretax contributions to a 401(k) effectively decrease your taxable income. This year you can deduct up to $15,500 in contributions to a 401(k), with an additional $5,000 deductible "catch-up" contribution allowed for workers who are 50 or older by Dec. 31. At the very minimum, contribute enough to take full advantage of any matching funds from your employer.

If you make $100,000 but contribute $15,500 to your 401(k), for example, you only have $84,500 of taxable income. (For simplicity's sake, this example assumes you have no other deductions.) Your income places you in the 28% tax bracket. But the contribution reduces your tax bill to $17,770.75 from $22,110.75.

Contributions to a traditional individual retirement account -- up to $4,000 per individual ($5,000 if you are 50 or older) -- may be tax-deductible as well. The extent of the deduction depends on your adjusted gross income and whether you or your spouse are covered by a retirement plan at work. What's more, you can defer taxes on any earnings in investments held in either a traditional IRA or a 401(k) until you retire and take distributions.

Unlike contributions to traditional IRAs, contributions to a Roth IRA are not tax deductible. But investments held in these accounts grow tax-free, which may be a powerful argument for setting one up. That's especially true for younger investors, who have a long time to take advantage of tax-free growth.

Don't wait until late December to contribute. The money you invest earlier in the year will have that much longer to earn tax-deferred returns -- maximizing your retirement savings at the same time you're minimizing your tax bill.

Up next: Prepare for the AMT.