401(k) Tax "Deduction": What You Need to Know

There’s a good chance that, when you signed up for your employer’s retirement plan, you signed up for a traditional 401(k). If this is the case, you’re probably receiving a 401(k) tax benefit that’s reducing your taxable income.

If you’re wondering how it all works with the 401(k) and taxes, here’s what you need to know.

Are 401(k) contributions tax deductible?

First, it’s important to understand that this is NOT a true tax deduction, but in a way, its better, because it’s easier for you. Unless you’re a business owner, you won’t claim your 401(k) contributions as tax deductible when you fill out your Form 1040. Instead, the money is taken out of your paycheck before federal taxes on your income are figured. This is how you save on taxes today. Your 401(k) pretax contribution comes out of your paycheck first thing, lowering your taxable income. Then, your taxes are taken out of your paycheck based on the smaller income number.

Let’s say you make $85,000 per year and are married filing jointly. This puts you in the 22% tax bracket. You can get a quick and dirty estimate of how much you could potentially save by multiplying your 401(k) contributions by your tax bracket. So, if you put aside 10% of your income ($8,500), you might see a savings of $1,870. This isn’t a fool-proof method, and your actual savings could vary based on state and local income taxes and other factors. The good news is some states don’t tax pretax employee 401(k) contributions either, so you save even more on your contributions.

Putting that money aside now, rather than paying it in taxes, can be a way to boost the potential of compounding returns. Yes, you’ll be taxed eventually when you withdraw money from your 401(k). But by then, you might have a smaller retirement income and be in a lower tax bracket. So when you do finally pay taxes, there’s a chance that the tax bill will be lower than if you’d paid taxes on that money today.

How much can you contribute to your 401(k)?

As an employee, there are limits to how much you can contribute to a 401(k) each year. The Internal Revenue Service (IRS) updates that information annually based on inflation and other factors. For 2023, the contribution limit is $22,500 and for 2024, the employee contribution limit is $23,000. For those who are 50 and older, it’s possible to make an additional catch-up contribution of $7,500 for a total of $30,000 in employee contributions in 2023 and a total of $30,500 in 2024.

With a 401(k), you need to make your contributions during the calendar year. So, if you want time to boost your retirement account and benefit from the special tax treatment, you need to get that extra money into your account with your December 31 payroll contributions.

What about employer contributions to a 401(k)? If your employer offers a matching contribution, that doesn’t affect your own contribution limit. It’s still $22,500 for 2023 and $23,000 in 2024. And most employer contributions aren’t taxable to you when they’re made. However, because the contributions do go into your retirement account, you’ll have to pay taxes on the money when you withdraw it, unless you rollover to an Individual Retirement Account (IRA) or other employer retirement plan like a 401(k). Note that “most” employer contributions aren’t taxable to you. There are exceptions now, because the SECURE 2.0 Act permits employers to make their contributions to you as Roth. While this new provision is still rare, your employer might ask you if you want your match or other employer contributions to be credited to your account as Roth. Just like an employee contribution made as Roth, an employer contribution made as Roth will be taxable in the year you receive the contribution, but then earnings and principal will generally be tax-free when you withdraw them in retirement. This new ability can be attractive to higher income folks who want more Roth tax-free income in retirement.

Your employer may also make additional contributions for you, sometimes called non-elective or profit-sharing contributions. These contributions usually change year to year and are based on your pay. These are sometimes based on your company’s profits. And there is an overall limit on the combined contributions made by you and your employer of $66,000 for 2023, or for 2024, a total combined amount of $69,000.

How do 401(k) contributions affect my IRA contribution limit? If you’re eligible to make 401(k) contributions—whether you do so or not—that may affect your personal and spouse’s IRA deductions. You can still fully contribute to your traditional IRA, but your deduction will now be based on your income. If you earn above the top threshold, you’ll have no deduction available. If you earn below the lower threshold, you’ll still be able to fully deduct your IRA contribution. 

Before you contribute to an IRA just for the tax deduction, consider your income and speak with an investment or tax professional about whether you’ll actually see a current-day tax benefit from your traditional IRA contribution. You can also review IRS Publication 590-A for lots more information on IRA contributions.

Paying taxes when you withdraw from your traditional 401(k)

Although your pretax 401(k) contributions are tax deductible today, you’ll eventually have to pay taxes on the money. It’s important to be aware of your marginal tax bracket, because any 401(k) withdrawals that aren’t rolled over into a qualified plan or IRA will be treated as regular income. If you withdraw $5,000 per month from your traditional 401(k)—and you don’t have other sources of income—your income will be $60,000, which puts you in the 12% tax bracket if you’re married filing jointly.

In this case, if your salary was $85,000 before retirement, and now your income is less, you’re in a lower tax bracket. So even though you’re paying taxes on that money now, you’ll still potentially have a smaller tax bill than if you’d paid taxes on it while you were working.

Deciding whether to contribute to a traditional 401(k) for the tax “benefit” is often about your expectations for income during retirement. If you think you can live on less during retirement, deferring the taxes until you’re in a lower tax bracket may make a lot of sense. If you expect to be in a higher tax bracket in retirement, then making Roth contributions, to have access to tax-free retirement income can make sense. The important thing is to save something. If you don’t save money now, then what will you live on in retirement? Saving in a 401(k) isn’t just about taxes. It’s about supporting you as you get older.

Watch out for early withdrawals.In general, you’re expected to wait until you reach age 59 and a half to begin withdrawing money from your 401(k). If you withdraw pretax money early, you’ll have to pay taxes on the money at your regular marginal tax rate. Plus, you might be stuck with a 10% penalty from the IRS.

There are exceptions to the penalty on early withdrawals, such as if you leave your job at age 55 or older or if you have a disability. But most people should wait to withdraw money until it can be done without risking a penalty.

What about the Roth 401(k)?

The Roth 401(k) is just a 401(k) that allows Roth-type employee contributions, in addition to all the contributions above. It’s not a completely different plan. Until now, Roth contributions are only made by employees—never as employer match or profit sharing. As discussed above, Roth employer contributions are permitted starting in 2023, but it is up to each business to decide if this provision makes sense for its employees. Few plans allow Roth employer contributions yet. If the 401(k) allows the employee Roth contributions, it’s up to the employee—you—to decide whether you contribute your savings as Roth or pretax—or you can do a combination of both types. You have flexibility to do what works for you.

When you make Roth contributions to your 401(k) account, your money comes out after taxes. You won’t see any tax savings in the year you make the contribution. But because you’ve already paid taxes on the money you contribute, when you withdraw money from a Roth account during retirement, it won’t be taxed either. Even better—once you reach retirement, you won’t be taxed on the earnings in your Roth account. Your Roth earnings are tax-free. Having tax-free income in retirement can be especially important when you get there. For example, your Medicare Part B premium is based on your taxable income. Less income could mean a lower premium.

If you think you’ll actually have a higher income and be in a higher tax bracket during retirement, it might make sense to make Roth contributions—rather than pretax contributions—to your 401(k). This will allow you to pay taxes on your income today on the Roth contribution to avoid the possibly higher tax rates that you expect in retirement.

An additional advantage to higher income folks is that there’s no income limit connected to 401(k) Roth contributions, so you won’t see your ability to contribute phased out like it is in a Roth IRA. 

Finally, remember that the limit on these employee Roth contributions is the same as the pretax employee contributions discussed above. If you make both pretax and Roth employee contributions in 2023, you get one $22,500 limit and one $23,000 limit for 2024 (or $30,000 in 2023 and $30,500 in 2024, if you’re age 50 or older).

Other ways to reduce your taxable income

The pretax traditional 401(k) isn’t the only way to increase your tax efficiency. You can reduce your taxable income by contributing to an HSA or FSA, or consult with a professional to see if it’s possible to pay pretax insurance premiums. These strategies, when combined with your pretax traditional 401(k) contributions, can further reduce your tax bill and help you put that money to work today so it has more time to potentially grow in the future.

Bottom line

The traditional 401(k) can potentially be a great tool to help you save for the future in a tax-efficient manner. If your employer allows Roth employee contributions, this offers additional tax-planning benefits once you get to retirement and begin spending your nest egg. As you get closer to retirement, you can maximize your benefits by consulting with a professional to help you make orderly and planned withdrawals.

TD Ameritrade does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances.

Maximum contribution limits cannot be exceeded. Contribution limits provided are based on federal law as stated in the Internal Revenue Code. Applicable state law may be different.