Are 401(k) Contributions Tax Deductible?

A 401(k) is a popular retirement savings plan that allows employees to contribute a portion of their earnings on a tax-deferred basis, often with matching contributions from their employer.

Understanding the tax implications behind 401(k) contributions is important for retirement planning. Depending on which type of 401(k) account you open and how you contribute, you can maximize potential tax savings, impacting how you pay income taxes now and during retirement.

In this post, we’ll discuss how 401(k) contributions affect your gross income, tax return, total federal tax due, and overall financial planning.

Traditional 401(k) Contributions and Tax Deductions

Traditional 401(k) contributions can significantly impact an individual’s taxable income — and add to tax savings — because they’re made with pre-tax dollars. This is unlike a Roth 401(k), where you make after-tax contributions.

Let’s dive deeper into how pre-tax contributions —and marginal tax rates — play a role in reducing your tax burden while saving for retirement.

Pre-tax contributions

When you contribute to a traditional 401(k), you do so on a pre-tax basis, reducing your take-home pay. This means the amount you contribute is deducted from your gross income before federal taxes and state taxes are paid.

This reduces your taxable income, lowering the amount you pay taxes on when you file your federal income tax return at the end of the year.

You’ll still pay Social Security and Medicare tax on your contributions, but you won’t pay federal or state income tax on them.

How traditional 401(k) contributions lower taxes

To understand the full impact of tax savings related to traditional 401(k) contributions, we’ll need to explore marginal tax rates and tax brackets.

• Your marginal tax rate is the percentage of tax you pay on your last dollar of income. By contributing to a traditional 401(k), taxpayers lower their taxable income, which may also result in a lower marginal tax rate and a reduced tax liability.
• Tax brackets represent sections of income, and higher levels of income are taxed at higher tax rates.

For example, if you make $60,000 annually and contribute $5,000 to your traditional 401(k), your taxable income drops to $55,000. This reduction in taxable income might also bring you down to a lower tax bracket, leading to tax savings.

Remember that you’ll need a complete picture of your finances to determine your tax bracket, so you should consider speaking to a tax advisor in advance of making any sort of tax-related decision.

The tax savings from traditional 401(k) contributions are not considered tax credits; instead, contributions made on a pre-tax basis can reduce taxable income and overall tax liability in the year of contribution.

In addition, a 401(k) rollover done correctly will allow you to move assets into other qualified retirement accounts, like a traditional IRA, without incurring taxes.

Roth 401(k) Contributions

Your employer may offer two types of 401(k)s, Roth and traditional. Roth 401(k) accounts accept after-tax contributions and have different tax implications than traditional 401(k) contributions.

Let’s explore the differences between the two.

Post-tax contributions

Unlike traditional 401(k) contributions, Roth contributions are made on an after-tax basis. This means you pay income tax on your contributions now, but qualified withdrawals in retirement are tax-free.

While you won’t see an immediate reduction in your tax bill today, the long-term benefits of tax-free withdrawals can be significant.

Comparison between traditional and Roth 401(k) contributions

When deciding between a traditional or Roth 401(k), there are several factors you’ll need to consider:

• Many individuals choose the Roth account when they anticipate being in a higher income tax bracket in retirement than in the present.
• Roth accounts are currently bound by Required Minimum Distribution (RMD) requirements, but this is slated to change in 2024 when RMDs will no longer be required from Roth 401(k)s. On the flip side, traditional 401(k) accounts mandate that you begin withdrawing regular amounts at age 73, and all withdrawals are taxable at your highest tax rate.
  • This means that beginning in 2024, Roth accounts can be especially effective if you’re planning to keep the money invested to pass on to your beneficiaries.
• Roth accounts must be active for five years before any earnings are eligible for penalty-free distributions, so if you’re retiring in the next few years, a traditional 401(k) may be more suitable.

Remember that because you pay income taxes on Roth contributions, your tax bill won’t be reduced in the current year.

Carefully consider your personal finances and retirement savings goals before selecting which account to open.

Annual Contribution Limits

Every year, the IRS outlines the maximum contributions individuals can make to a 401(k) account. It’s essential to know these maximum contribution limits and understand the opportunities available for individuals over 50 to accelerate their savings through catch-up contributions.

Maximum contribution amounts for 2023

In 2023, the maximum 401(k) contributions for traditional and Roth accounts are:

• For those under 50: $22,500.
• For those 50 and over: $22,500, plus a $7,500 catch-up contribution.

Catch-up contributions for individuals aged 50 or older

Catch-up contributions allow individuals over 50 to contribute an additional amount to their 401(k) plan above the annual limit to help accelerate savings as one nears retirement.

In 2023, the catch-up contribution for a traditional or Roth 401(k) is $7,500.

Distributions from a 401(k)

Depending on your age and circumstances, withdrawing funds from your traditional 401(k) will have various tax implications. Let’s explore some common scenarios:

• Taxation of withdrawals for traditional 401(k)s: Withdrawals from traditional 401(k) accounts during retirement are subject to income tax because your contributions went in tax-deferred. The amount withdrawn is considered taxable income and is taxed at your ordinary income tax rate at the time of withdrawal. Paying income tax on withdrawals in retirement is avoidable if you have a Roth 401(k) instead.
• Early withdrawal penalties: Withdrawing funds from a 401(k) before the age of 59½ can result in a 10% early withdrawal penalty in addition to the income tax due on the withdrawal amount.
• Comparing tax rates during working years and retirement: Individuals will likely have lower tax rates during retirement compared to their working years. By deferring taxes on 401(k) contributions until retirement, you could potentially benefit from lower tax rates and achieve substantial tax savings when you finally take the money out in retirement.

Contributions and Earnings

Your contributions to a traditional 401(k) will have different tax treatment than your usual earnings, so it’s essential to have a full understanding to manage your financial planning. Here are some key points to remember:

• Tax treatment of investment income in 401(k)s: Investment income within a 401(k) plan, such as dividends and capital gains, are tax-deferred until you withdraw funds during retirement. This deferral allows for the compounding effect on investment earnings, which can significantly boost your retirement savings. This includes any funds from your employer contributions as well.
• Advantages of maximizing 401(k) contributions: Contributing as much as possible to a 401(k) plan can lead to a larger retirement nest egg than investing in a regular brokerage account. This is due to tax deferral on compounded earnings and the potential for employer-matching contributions.

What Are Saver’s Credits?

Saver’s Credits are designed to encourage retirement savings plans for low- to moderate-income individuals. By contributing to qualified retirement accounts, such as 401(k) plans or IRAs, eligible taxpayers can receive a non-refundable tax credit that reduces their tax liability.

The amount of the credit is a percentage of the 401(k), or IRA contributions made, depending on the taxpayer’s adjusted gross income and filing status.

Alternative Ways to Reduce Taxable Income

In addition to 401(k) contributions, there are other tax-advantaged accounts and strategies, such as Health Savings Accounts (HSAs), Flexible Spending Accounts (FSAs), and traditional IRAs, which can help reduce taxable income.

• Health Savings Accounts (HSAs): HSAs are available to individuals with high-deductible health plans (HDHPs) and provide a tax-advantaged way to save for medical expenses. Contributions to an HSA are tax-free, earnings grow tax-free, and distributions for qualified medical expenses are tax-free.

• Flexible Spending Accounts (FSAs): FSAs are employer-established accounts that allow employees to set aside pre-tax dollars for qualified medical and dental expenses. Contributions to an FSA are tax-free, and withdrawals for eligible expenses are tax-free.

• Traditional IRAs and other retirement accounts: Contributions to traditional IRAs are often tax-deductible, depending on income and other factors. Other retirement accounts, such as Roth IRAs, offer long-term tax benefits, including tax-free withdrawals during retirement, just like Roth 401(k)s.
  • These accounts are also available to small business owners or self-employed individuals, not just those working for a large employer. They can help lower your taxable income in a given tax year, sometimes boosting your refund from your income tax return.

FAQs

How much does contributing to a 401(k) reduce taxes?

The tax reduction resulting from 401(k) contributions depends on your taxable income and marginal tax rate. Contributing to a traditional 401(k) reduces your taxable income, lowering your tax liability.

For example, if you’re in the 24% tax bracket and contribute $10,000 to a traditional 401(k), you could potentially save $2,400 in taxes ($10,000 x 24%).

Can I claim 401(k) contributions on my taxes?

Yes. Traditional 401(k) contributions are automatically deducted and reported by your employer. Your W-2 form will show your taxable income after accounting for your 401(k) contributions, so there’s no need to claim these contributions separately on your income tax return.

Is it better to contribute to a 401(k) pre- or post-tax?

Deciding between pre-tax (traditional) and post-tax (Roth) 401(k) contributions depends on factors such as your current and future tax brackets and your retirement income expectations.

Pre-tax contributions to a traditional 401(k) offer immediate tax savings by reducing taxable income, while post-tax Roth contributions provide tax-free withdrawals during retirement.

Need Help Managing Your 401(k) Plan?

Understanding the tax implications of 401(k) contributions is essential for effective financial planning. It’s crucial to consider your personal finance goals, retirement plan strategy, and tax planning needs when deciding on your 401(k).

Consulting with a financial professional for personalized advice can help you make the right choices.

Capitalize is here to help you navigate the world of 401(k) rollovers. Learn more about how we can help you start your financial journey.