As you’ve been planning and saving for retirement, you may have heard that there’s a “401(k) tax deduction.” And while there are definitely tax benefits associated with contributing to a 401(k) account, the term 401(k) tax deduction isn’t accurate.
You cannot deduct your 401(k) contributions on your income tax return, per se — but the money you save in your 401(k) is deducted from your gross income, which can potentially lower how much tax you owe.
This is not the case for a Roth 401(k), a relative newcomer in terms of retirement accounts. These accounts are funded with after-tax contributions, and so tax deductions don’t enter the picture.
Key Points
• 401(k) contributions are not tax deductible, but they lower your taxable income.
• Roth 401(k) contributions are made with after-tax money and do not provide tax deductions.
• Contributions to employer-sponsored plans like 401(k) or 403(b) are taken out of your salary and reduce your taxable income.
• 401(k) withdrawals are taxed as income, and early withdrawals may incur additional penalties.
• Making eligible contributions to a 401(k) or IRA can potentially qualify you for a Retirement Savings Contributions Credit.
How Do 401(k) Contributions Affect Your Taxable Income?
The benefits of putting pre-tax dollars toward your 401(k) plan are similar to a tax deduction, but are technically different.
• An actual tax deduction (similar to a tax credit) is something you document on your actual tax return, where it reduces your gross income.
• Contributions to an employer-sponsored plan like a 401(k) or 403(b) are actually taken out of your salary, so that money is not taxed, and thus your taxable income is effectively reduced. But this isn’t technically a tax deduction.
People will often say your 401(k) contributions are tax deductible, or you get a tax deduction for saving in a 401(k), but it’s really that your 401(k) savings are deducted from your salary, and not taxed.
The money in the account also grows tax free over time, and you would pay taxes when you withdraw the money.
Example of a 401(k) Contribution
Let’s say you earn $75,000 per year. And let’s imagine you’re contributing 10% of your salary to your 401(k), or $7,500 per year.
Your salary is then reduced by $7,500, an amount that is noted on your W2. As a result, your taxable income would drop to $67,500.
Would that alone put you in a lower tax bracket? It’s possible, but your marginal tax rate is determined by several things, including deductions for Social Security and Medicare taxes, so it’s a good idea to take the full picture into account or consult with a professional.
Recommended: IRA vs 401(k): What’s the Difference?
Do You Need to Report 401(k) Contributions on Your Tax Return?
The short answer is no. Because 401(k) contributions are taken out of your paycheck before being taxed, they are not included in taxable income and they don’t need to be reported on a tax return (e.g. Form 1040, U.S. Individual Income Tax Return or Form 1040-SR, U.S. Tax Return for Seniors).
Your employer does include the full amount of your annual contributions on your W2 form, which is reported to the government. So Uncle Sam does know how much you’ve contributed that year.
You won’t need to report any 401(k) income until you start taking distributions from your 401(k) account — typically after retiring. At that time, you’ll be required to report the withdrawals as income on your tax return, and pay the correct amount of taxes.
When you’re retired and withdrawing funds (aka taking distributions), the hope is that you’ll be in a lower tax bracket than while you were working. In turn, the amount you’re taxed will be relatively low.
How the Employer Match Works
When an individual receives a matching contribution to their 401(k) from their employer, this amount is also not taxed. A typical matching contribution might be 3% for every 6% the employee sets aside in their 401(k). In this case, the matching money would be added to the employee’s account, and the employee would not owe tax on that money until they withdrew funds in retirement.
How Do 401(k) Withdrawals Affect Taxes?
The tax rules for withdrawing funds from a 401(k) account differ depending on how old you are when you withdraw the money.
Generally, all traditional 401(k) retirement plan distributions are eligible for income tax upon withdrawal of the funds (note: that rule does not apply to Roth 401(k)s, since contributions to those plans are made with after-tax dollars, and withdrawals are generally tax free).
If you withdraw money before the age of 59 ½ it’s known as an “early” or “premature” distribution. For these early withdrawals, individuals have to pay an additional 10% tax as a part of an early withdrawal penalty, with some exceptions, including withdrawals that occur:
• After the death of the plan participant
• After the total and permanent disability of the plan participant
• When distributed to an alternate payee under a Qualified Domestic Relations Order
• During a series of substantially equal payments
• Due to an IRS levy of the plan
• For qualified medical expenses
• Certain distributions for qualified military reservists called to active duty
For individuals looking to withdraw from their 401(k) plan before age 59 ½, a 401(k) loan may be a better option that will not result in withdrawal penalties, but these loans with their own potential consequences.
How Do Distributions From a 401(k) Work?
Once you turn 59 ½, you can withdraw 401(k) funds at any time, and you will owe income tax on the money you withdraw each year. That said, you cannot keep your retirement funds in the account for as long as you wish.
When you turn 72, the IRS requires you to start withdrawing money from your 401(k) each year. These withdrawals are called required minimum distributions (or RMDs), and it’s important to understand how they work because if you don’t withdraw the correct amount by Dec. 31 of each year, you could get hit with a big penalty.
Prior to 2019, the age at which 401(k) participants had to start taking RMDs was 70 ½. The rule changed in 2019 and the required age is now 72. When you turn 72 the IRS requires you to start taking withdrawals from your 401(k), or other tax-deferred accounts (like a traditional IRA or SEP IRA).
If you don’t take the required minimum amount each year, you could face another requirement: to pay a penalty of 50% of the withdrawal you didn’t take.
All RMDs from tax-deferred accounts like 401(k) plans are taxed as ordinary income. If you withdraw more than the required minimum, no penalty applies.
Recommended: Should You Open an IRA If You Have a 401(k)?
What Are Tax Saver’s Credits?
Making eligible contributions to an employer-sponsored retirement plan such as a 401(k) or an IRA can potentially lead to a tax credit known as a Retirement Savings Contributions Credit, or a Saver’s credit. There are three requirements that must be met to qualify for this credit.
1. Individual must be age 18 or older.
2. They cannot be claimed as a dependent on someone else’s return.
3. They can not be a student (certain exclusions apply).
The amount of the credit received depends on the individual’s adjusted gross income.
The credit amount is typically 50%, 20%, or 10% of contributions made to qualified retirement accounts such as a 401(k), 4013(b), 457(b), traditional or Roth IRAs.
For tax year 2023, the maximum contribution amount that qualifies for this credit is $2,000 for individuals, and $4,000 for married couples filing jointly, bringing the maximum credit to $1,000 for individuals and $2,000 for those filing jointly. Rollover contributions don’t qualify for this credit.
Alternatives for Reducing Taxable Income
Aside from contributing to a traditional 401(k) account, there are other ways to reduce taxable income while putting money away for the future.
Traditional IRA: Traditional IRAs are one type of retirement plan that can lower taxable income. Individuals may be able to deduct their traditional IRA contributions on their federal income tax returns. The deduction is typically available in full if an individual (and their spouse, if married) doesn’t have retirement plan coverage offered by their work. Their deduction may be limited if they or their spouse are offered a retirement plan at work, and their income exceeds certain levels.
SEP IRA: SEP IRAs are a possible alternative investment account for individuals who are self-employed and don’t have access to an employee sponsored 401(k). Taxpayers who are self-employed and contribute to an SEP IRA can qualify for tax deductions.
403(b) Plans: A 403(b) plan applies to employees of public schools and tax-exempt organizations, and certain ministers. Employees with 403(b) plans can contribute some of their salary to the plan, as can their employer. As with a traditional 401(k) plan, the participant doesn’t need to pay income tax on any allowable contributions, earnings, or gains until they begin to withdraw from the plan.
Charitable donations: It’s possible to claim a deduction on federal taxes after donating to charities and non-profit organizations with 501(c)(3) status. To deduct charitable donations, an individual has to file a Schedule A with their tax form and provide proper documentation regarding cash or vehicle donations.
To deduct non-cash donations, they have to complete a Form 8283. For donated non-cash items, individuals can claim the fair market value of the items on their taxes. from the IRS explains how to determine vehicle deductions. For donations that involve receiving a gift or a ticket to an event, the donor can only deduct the amount of the donation that exceeds the worth of the gift or ticket received. Individuals are generally required to include receipts when they submit their return.
Earned Income Tax Credit: Individuals and married couples with low to moderate incomes may qualify for the Earned Income Tax Credit (EITC). This particular tax credit can help lower the amount of taxes owed if the individual meets certain requirements and files a tax return — whether or not the individual owes money. Filing a return in this case can be beneficial, because if EITC reduces the amount of taxes owed to less than $0, then the filer may actually get a refund.
The Takeaway
Individuals who expect a 401(k) deduction come tax time may be disappointed to learn that there is no such thing as a 401(k) tax deduction. But they may be pleased to learn the other tax benefits of contributing to a 401(k) retirement account.
Contributions are made with pre-tax dollars, which effectively lowers one’s amount of taxable income for the year — and that may in turn lower the amount of income taxes owed.
Once an individual reaches retirement age and starts withdrawing funds from their 401(k) account, that money will be considered income, and will be taxed accordingly.
Another way to maximize your retirement savings: Consider rolling over your old 401(k) accounts so you can manage your money in one place with a rollover IRA. SoFi makes the rollover process seamless and simple. There are no rollover fees. The process is automated so you’ll avoid the risk of a penalty, and you can complete your 401(k) rollover quickly and easily.
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