Retirement Accounts

Retirement Accounts

Understanding 401(k)s

401(k) Rules

Cashing Out your 401(k)

Understanding Roth 401(k)s

Roth IRA Basics

Are 401(k) Contributions Tax Deductible?

Before you start heavily funding your 401(k) it’s important to know what the repercussions will be. You’ll pay taxes on the amount when you take the money out at retirement. This could be better or worse than paying taxes now, depending on your circumstances.

Stephanie Faris

Published January 12th, 2021

Key Takeaways
  • Although 401(k) contributions aren’t tax-deductible, the money goes in pre-tax, so it reduces your taxable income each year.
  • You will have to pay taxes when you take the money out, but you’ll be taxed based on your income tax bracket at that time.
  • You may qualify for a tax credit based on your yearly income.

Retirement savings accounts give you the option to fund your IRA or 401(k) before or after tax is taken out on your income. If your money is going into a traditional IRA or 401(k), no taxes will be taken out of your account when the money is put in. While the answer to, “Are 401(k) contributions tax-deductible?” is technically, “No,” putting some of your taxable income into your 401(k) does reduce your tax liability.

Before you start heavily funding your 401(k), though, it’s important to know what the repercussions will be. You’ll pay taxes on the amount when you take the money out at retirement. This could be better or worse than paying taxes now, depending on your circumstances.

Are 401(k) Contributions Tax Deductible?

There’s a good reason 401(k) plans are often advised as a tax-reduction strategy. But it isn’t that you take your 401(k) contributions as a tax deduction. But your pre-tax contributions to your 401(k) offset your annual taxable income.

Is 401(k) pre-tax? Yes. Money is typically taken out of your pay and deposited into your 401(k) account before income taxes are taken out. That means the money you’re putting into your 401(k) reduces the amount of taxes that are withheld from your paycheck, and you won’t owe them at tax time. Instead, you’ll pay those taxes when you take the money out of the account, typically after you’ve retired.

How Taxes Are Calculated Based On Your Tax Bracket

One most important thing to look at as you’re considering 401(k) tax benefits is how tax brackets apply to you. Your annual income influences the amount you pay in taxes each year. For 2021, here are the tax brackets:

Tax RateSingle FilersMarried Filing JointlyMarried Filing Separately
10 percent$0-9,950$0-19,900$0-9,950
12 percent$9,951-40,525$19,901-81,050$9,951-40,525
22 percent$40,526-86,375$81,051-172,750$40,526-86,375
24 percent$86,376-164,925$172,751-329,850$86,376-164,925
32 percent$164,926-209,425$329,851-418,850$164,926-209,425
35 percentOver $209,425Over $418,850Over $209,425

Here’s where the tax brackets come into play. Your 401(k) tax deduction comes because you don’t pay taxes on the money now. You will get a tax bill when you take the money out of the account. There are some issues to consider with that:

  • Tax rates can and do change. If you’re retiring soon, it likely won’t be much, but the TCJA tax cuts expire in 2025, which could bump them up a bit. If you’re planning for a retirement 10 or 20 years down the line, that tax savings you’re enjoying now could be counteracted.
  • Your post-retirement income will look different. If you’re paying 22 percent now, consider what your income will likely be after retirement. Your 401(k) deduction now might actually result in you paying less in taxes because the money is taxed at a much lower percentage based on that year’s income.
  • You’ll have less money to give to taxes. Although it will be great to pay less in taxes, you’ll also have less money coming in each month. That means the after-tax 401(k) contributions you made during your younger years, when you had more income, will have taxes deducted when you’re likely on a much tighter budget.

Distributions From a 401(k)

Now that you’ve seen the answer to, “Are 401(k) contributions pre-tax?” it’s important to take a look at how your money will be taken at retirement. Whether you were faced with 401(k) pre-tax or post-tax, you would still need to plan for your retirement cash flow.

Typically starting at the age of 59½, you can start taking money out of your 401(k) without paying a 10 percent penalty. You’ll need to look at your plan’s rules as to how this works, but typically it will either be paid as an annuity, which is a fixed amount each year, or as lump-sum withdrawals. But how are 401(k) contributions taxed at retirement? The money will be withheld from your distributions, the same way they were withheld from your paycheck when you were working. At tax time, you’ll receive Form 1099-R, which you’ll use to report the money you took out during the tax year. You’ll report this amount on your 1040.

The Saver’s Tax Credit

Socking money away in your 401(k) can save you in another way. Currently, the IRS is offering a tax credit of up to $1,000 for qualifying taxpayers. Married couples filing jointly can take as much as $2,000. Called the Saver’s Tax Credit, this 401(k) contribution tax is based on your income.

Here are the Saver’s Tax Credit rates for 2021:

Credit RateMarried Filing JointlyHead of HouseholdSingle Filers
50% of your contribution ($1,000/$2,000 max)Under $39,500Under $29,625Under $19,750
20% of your contribution$39,501 - $43,000$29,626 - $32,250$19,751 - $21,500
10% of your contribution$43,001 - $66,000$32,251 - $49,500$21,501 - $33,000
0% of your contributionMore than $66,000More than $49,500More than $33,000

Final Thoughts

Although there isn’t a 401(k) contribution tax deduction, per se, you do reduce your taxable income by putting money, pre-tax, into your 401(k). But most importantly, you’ll have money waiting for you when you’re ready to retire. We recommend working with a Certified Financial Planner® to find the best ways to reduce your tax burden both now and after retirement.

Retirement Accounts

Retirement Accounts

Understanding 401(k)s

401(k) Rules

Cashing Out your 401(k)

Understanding Roth 401(k)s

Roth IRA Basics

Author

Stephanie Faris

Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a writer for a credit card processing service and has written about finance for numerous marketing firms and entrepreneurs. Her work has appeared on Money Under 30, The Motley Fool, MoneyGeek, E-commerce Insiders, and GoBankingRates.