How Do 401(k) Tax Deductions Work?

Learn About the Benefits of Saving for Retirement in a Pre-Tax 401(k)

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401(k) plans were first established by Congress to encourage workers to save for retirement. Besides accumulating money for achieving financial independence in retirement down the road, traditional 401(k) plans offer significant tax benefits for today.

The amount of your 401(k) contributions directly reduces your taxable income. As a result, this means you will pay tax on less income overall. Once you determine the amount you are able to save in income taxes, you will often discover that the contributions cost you less than you would have expected.

 

How do 401(k) contributions reduce your taxable income?

Exactly how much you will pay in Federal income taxes is based on your taxable income. There are a few financial planning strategies you can use to reduce your taxable. Some common strategies to reduce your taxable income include setting aside funds to pay for health related expenses in an HSA or FSA, paying for child care expenses with a Dependent Care FSA, pre-tax insurance premiums, saving in a deductible IRA, and contributing to traditional 401(k) plan. If you decrease your taxable income, you decrease the amount of tax you pay.    

Keep in mind that 401(k) contributions are typically pre-tax, meaning that your taxable income is reduced by the amount you put into your 401(k) account. Exceptions include Roth 401(k) and other after-tax 401(k) contributions.

Because pre-tax contributions reduce taxable income and you pay less tax overall, your take-home pay will not be reduced by the full amount of your contribution.

Scenario 1:

Here is an example of how it works for a single person with a $45,000 salary contributing 10 percent of their gross salary

Gross pay if paid twice per month ($45,000 per year):  $1,875
Net pay if paid twice per month without a 401(k) contribution: $1,559.43
Net pay if paid twice per month WITH a $375 401(k) contribution: $1,394.43
Difference: $165

Even though this person contributes $187.50 per paycheck, because they are paying tax on less income, their paycheck is only reduced by $165. The $22.50 difference represents the pre-tax savings. (Note: Actual pre-tax savings may be greater if subject to state or local income taxes).

Scenario 2:

Here is a similar example of a single person with a $90,000 salary contributing 10 percent of their gross salary: 

Gross pay if paid twice per month ($90,000 per year):  $3,750
Net pay if paid twice per month without a 401(k) contribution: $3,044.33
Net pay if paid twice per month WITH a $375 401(k) contribution: $2,753.99
Difference: $308.34

Even though this person contributes $375.00 per paycheck, because they are paying tax on less income, their paycheck is only reduced by $308.34. The $66.66 difference represents the pre-tax savings. (Note: Actual pre-tax savings may be greater if subject to state or local income taxes).

Scenario 3:

Here’s another example for a married individual with a $80,000 salary also contributing 10 percent to a 401(k) and claiming zero allowances on Form W-4:

Gross pay if paid twice per month ($80,000 per year):  $3,333
Net pay if paid twice per month without a 401(k) contribution: $2,825.31
Net pay if paid twice per month WITH a $333.30 401(k) contribution: $2,532.01
Difference: $293.30

Even though this person contributes $333 per paycheck, because they are paying tax on less income, their paycheck is only $293.30 smaller.

Understanding Your Marginal Tax Bracket

The tax savings becomes more significant when you are in a higher marginal income tax bracket. Recent tax law changes make it important to review how much you are benefiting from deducting your 401(k) contributions. If you enjoy getting those tax savings today and anticipate being at the same or a lower tax bracket during your retirement years you should continue making pre-tax contributions to a 401(k) plan. However, if you anticipate being in a higher tax bracket or prefer the idea of tax-free growth of earnings you may prefer making contributions to a Roth 401(k).

Summary

If you are like most people, saving for retirement is an important part of your financial life plan.

Paying less tax overall because your contributions reduce taxable income is an added bonus. Be sure to take advantage of the 401(k) plan offered by your company and enjoy the benefits of saving money on a pre-tax basis.   In a 401(k) plan, your money also grows tax-deferred, which means that you don’t have to pay any taxes on your gains until you withdraw the funds at retirement. You may be able to accumulate more in your 401(k) plan than in your taxable accounts because you are not paying tax every year on the earnings.

There are other reasons to save for retirement in 401(k) accounts. Some employers offer matching funds as an additional incentive to save money towards retirement. Company matches are typically subject to a vesting schedule, which is the period of time that must pass for the matching amount to become yours if you were to leave your employer. You are always 100 percent vested in the amount that you contribute.