Not only is a 401(k) plan a big slice of the retirement savings pie for many, they can offer significant tax savings, too, as pretax contributions to a 401(k) plan can reduce annual tax liability. But confusion sometimes arises over the question “Are 401(k) contributions tax deductible?” The answer is: Not exactly. You don’t deduct 401(k) contributions from your tax obligation. Instead, your taxable salary is reduced by the amount of the contribution.
401(k) contributions and tax implications
Employee contributions to a 401(k) company plan are known as elective deferrals, meaning an employee authorizes and designates a portion of their salary to be contributed to the 401(k) plan.
In the most common scenario, elective deferrals are made on a pretax basis, though some employers allow deferrals on an after-tax basis, too. For pretax deferrals, the contribution amount is subtracted from gross pay, thus reducing taxable income. It feels like a tax deduction, but technically, it’s more like a salary reduction.
This doesn’t mean the contribution will never be taxed. 401(k) taxes will apply during retirement when the individual starts taking distributions. At that time, the individual may be in a lower tax bracket.
How the 401(k) can reduce taxes
A simple example shows how 401(k) contributions can lower an employee’s taxable income. Imagine a worker with a salary of $90,000 who is in the 22% income tax bracket. This worker contributes $10,000 in elective deferrals to a 401(k) for the year. This would reduce their taxable income to $80,000. Because this worker is close to the borderline between tax brackets, the salary reduction results in a lower tax bracket, from 22% to 12%. The $10,000 contribution is tax deferred, meaning they pay taxes on the amount when it’s withdrawn, usually in retirement.
The saver’s tax credit
Besides elective deferrals, those who save in employer retirement plans might qualify for the IRS’s saver’s tax credit. This credit can save individuals up to $1,000 ($2,000 for joint filers) in taxes. It applies only when adjusted gross income is below these 2022 levels set by the IRS: $68,000 as a married joint filer, $51,000 as a head of household, $34,000 for any other filing status.
To calculate the saver’s tax credit, you would take 50%, 20%, or 10% of the amount contributed to a traditional individual retirement account (IRA), Roth IRA, 401(k), SIMPLE IRA, ABLE account, SARSEP, 403(b) or 457(b) plan. The percentage reduction depends on income level.
Tax savings for employers who contribute to their employees’ 401(k)s
While employees don’t need to deduct contributions to a 401(k), employers can deduct the matching contributions they make from their business profit. Beyond this, employers could benefit from recent changes to retirement plan rules found in the SECURE Act, which became law in 2020.
- Tax credits for small business retirement plans. For small businesses that would otherwise find the cost of providing a 401(k) prohibitive, the act offsets costs by giving a tax credit to small employers (those with up to 100 employees) when they start a workplace 401(k) plan.
- Pooled Employer Plans can save on administration fees. Another provision permits access to Pooled Employer Plans (PEPs). Small employers can team up to offer a collective 401(k) plan to employees, which can save on administrative costs.
How to report 401(k) contributions on a tax return
Individual savers don’t have to report 401(k) contributions on tax returns. Every contribution made to the plan with pretax money already reduces taxable income and tax withholding.
The employer will report elective deferrals on an employee’s W-2 Wage and Tax Statement. While they aren’t considered income on the federal tax return, Social Security, Medicare, and Federal Unemployment Taxes do count them as current taxable income.
Other ways to reduce taxable income
There are other viable options for retirement savers who are looking to reduce taxes, including IRAs and 403(b) plans.
Some, but not all, types of IRAs can have immediate tax benefits.
- Traditional IRAs. Traditional IRAs allow federal income tax deductions on contributions, as much as $6,000 a year; those over 50 can invest $7,000. A full deduction can be taken if the employer doesn’t offer a retirement plan. Limits on the deduction amount apply when an individual or spouse has an employer retirement plan, and when income exceeds certain levels.
- SEP IRAs. The SEP IRA is designed for self-employed individuals who don’t otherwise have access to an employer 401(k). Contributions to a SEP IRA can qualify as tax deductions from business income—or up to 25% of net business profits with an upper limit of $61,000 for 2022.
- Roth IRAs don’t apply. Because Roth IRAs are funded with after-tax contributions, they don’t have immediate tax benefits.
A 403(b) plan is like a 401(k), but it’s designed for employees at public schools, tax-exempt organizations, and in some circumstances, clergy. Employees can make elective deferrals and the employer can match contributions. Income tax won’t apply until retirement distributions are taken.
401(k) Plan Types
- Traditional 401(k) plans. Employees can make pretax elective deferrals through payroll deductions, and employers can make matching contributions, which in some cases are subject to a vesting schedule.
- Roth 401(k) plans. Some employers offer Roth 401(k) plans. The difference between a traditional and Roth 401(k) is that contributions to Roth plans are taxed, but earnings and withdrawals during retirement are tax-free.
- Safe harbor 401(k) plans. A safe harbor 401(k) plan is designed to let all employees receive employer contributions. In a safe harbor for 401(k), average contributions of high-wage earners can’t exceed other plan participants by more than 2%.
- SIMPLE 401(k) plans. Qualifying small businesses can set up a SIMPLE 401(k) plan, which stands for Savings Incentive Match Plan for Employees. Employers with fewer than 100 workers who earned at least $5,000 per year can participate in this plan.
The bottom line
By making elective deferral contributions to a 401(k) plan, employees will reduce their current taxable income and withholding without having to take a tax deduction on the federal income tax form. Tax obligations are deferred until distributions are taken in retirement; this is when a 401(k) is taxed. Other methods to reduce taxes such as the saver’s credit and funding IRAs with pretax dollars may be available for those who qualify.
Side note: Try Titan’s free 401(k) Calculator to project how much your 401(k) will give you in retirement.