Are 401(k) Contributions Tax Deductible?

Contributions to qualified retirement plans, such as traditional 401(k)s, tax-deductible. However, you don't have to report them on your tax return, as your employer will have already lowered your taxable income by the amount of your contributions. Traditional 401(k) contributions are made on a pre-tax basis, which removes them from your taxable income and thus reduces the taxes you'll pay for the year.

How 401(k) Contributions Lower Taxes

Because plan contributions to traditional 401(k) plans shrink your taxable income, your taxes for the year should be reduced by the contributed amount multiplied by your marginal tax rate, as per your tax bracket. 

The higher your income, and thus your tax bracket, the more significant the tax savings from contributing to a plan. Take, for example, a single earner who makes $208,000 a year and also contributes $5,000 annually to a plan. They are in the 32% tax bracket for 2022. Their tax savings from the contribution is, therefore, $5,000 multiplied by 32%, or $1,600.

Note, however, that if you choose the Roth 401(k) option, your contributions won't reduce your taxable income. Instead, your contributions are made with post-tax income. However, during retirement, distributions aren't taxed.

There are limits to how much you can contribute tax-free to such a plan. For 2022, the annual limit is $20,500. Those age 50 or older can make an additional catch-up contribution each year of $6,500. In 2023, these annual limits increased to $22,500 of annual contributions and $7,500 of catch-up contributions.

Distributions From a 401(k)

Of course, you don't escape paying taxes forever on your traditional 401(k) contributions, only until you withdraw them from the plan. When you do so, you must pay income tax on the withdrawals, or "distributions," at your applicable tax rate at that time. If you withdraw funds when you're younger than 59½, you'll likely pay an early withdrawal penalty of 10% of the amount as well.

However, chances are you'll pay less to withdraw funds from the plan in retirement than you did when you made the contributions. That's because your income (and tax rate) are likely to have dropped by then, compared to your working years.

For example, if you started your withdrawals during retirement at $5,000 a year to supplement $75,000 in annual Social Security payments—with an income of $80,000 a year, you'd be in the 22% tax bracket and would pay $1,100 on those plan withdrawals.

Contributions and Earnings

Qualified retirement plans require this tax treatment not only of withdrawals but from the original contributions to the account. Any investment income the contributions may have earned in the years between the contribution and its distribution can also be withdrawn, with the same applicable income tax.

By doing so, it can help make maximizing your contributions to a retirement account a better investment strategy than directing money to a regular brokerage account. Why? Skipping paying tax on your account contributions allows you to have more capital working on your behalf during the years leading up to retirement.

As an example, a person in the 22% tax bracket with 20 years until they retire might either contribute a pre-tax $400 a month to a 401(k) plan or divert the same amount of earnings to a brokerage account. The latter option would yield only a monthly contribution of $312 after paying a 22% tax on the $400 in income.

The extra $88 per month from the 401(k) option not only increases contributions but further expands the nest egg by having a larger balance on which earnings can compound over decades. The difference between the scenarios could amount to tens of thousands over the long run.

Other Ways to Reduce Taxable Income

Although contributing to tax-advantaged retirement accounts is one of the best ways to reduce your taxable income, you also have other options.

Health Savings Account (HSA)

Health savings accounts (HSAs) are tax-advantaged accounts that are allowed for individuals with high-deductible health plans (HDHPs). HSAs are meant to be used for medical expenses, such as dental and prescription drugs. Contributions are made to the account tax-free. As well, earnings and distributions that are used for qualified medical expenses are also tax-free.

Flexible Spending Account (FSA)

Flexible spending accounts (FSAs) are another tax-advantaged account. Employers establish these accounts for employees. Contributions are made tax-free. Account withdrawals, when used for medical and dental services, are also tax-free.

Traditional IRA/Other Retirement Accounts

Other retirement vehicles may also be deductible. For example, contributions to traditional IRAs can also be deducted on your individual federal income tax amount. Similar to a 401(k), Roth IRAs are not deductible but instead have longer-term tax benefits.

The Bottom Line

Traditional 401(k) contributions are automatically deducted from your tax statements received from your employer. You'll have to pay taxes on what you earn, but you'll receive immediate, upfront tax benefits. On the other hand, Roth 401(k) contributions are not deductible but instead provide long-term tax benefits on investment earnings.