401(k) Tax "Deduction": What You Need to Know

There's a good chance that, when you signed up for your employer's retirement plan, you signed up for a traditional 401(k). If this is the case, you're probably receiving a 401(k) tax benefit that's reducing your taxable income.

If you're wondering how it all works with the 401(k) and taxes, here are some details you need to know.

A pretax 401(k) contribution isn't really a true tax deduction because this amount does not appear on your tax return. Instead, the money is taken out of your paycheck, which lowers the income reported on you W-2. In the end, pretax 401(k) contributions have the same effect as a tax deduction, it's just easier on you because you never have to report this money on your tax return.

Here's a simple example. Let's say you're single, and after taking the standard deduction, your taxable income is $85,000 per year. This puts you in the 22% tax bracket. You can get a quick and dirty estimate of how much a tax-deductible contribution to your 401(k) would save you in taxes by multiplying your contribution by your tax bracket. So, if you contributed $20,000 to your 401(k), you might see a tax savings of $4,400. This isn't a fool-proof method, and your actual savings could vary based on state and local income taxes and other factors.

Putting that money aside now, rather than paying it in taxes, can be a way to boost the potential of compounding returns. Yes, you'll be taxed eventually when you withdraw money. But by then, you might have a smaller retirement income and be in a lower tax bracket. So, when you do finally pay taxes, there's a chance the tax bill will be lower than if you'd paid taxes on that money today.

As an employee, there are limits to how much you can contribute to a 401(k) each year. The Internal Revenue Service (IRS) updates that information annually based on inflation and other factors. For 2025, the employee contribution limit is $23,500. For those 50 and older, it's possible to make an additional catch-up contribution of $7,500 for a total of $31,000 in 2025. For those 60 to 63, the SECURE 2.0 ACT added in a super, or higher, catch-up contribution of $11,250 in 2025.

With a 401(k), you need to make your contributions during the calendar year. So, if you want time to boost your retirement account and benefit from the special tax treatment, you need to get that extra money into your account before year-end.

What about employer contributions to a 401(k)? If your employer offers a matching contribution, it doesn't affect your own contribution limit. It's still $23,500 in 2025. If your employer's contributions are pretax, that additional money won't be taxable. However, because the contributions do go into your retirement account, you'll have to pay taxes on the money when you withdraw.

Though most employer contributions are pretax, that's may not always be the case. The SECURE 2.0 Act permits employers to make their matching contributions to a Roth account. While this new alternative is still fairly rare, your employer might ask if you want your match or other employer contributions to be credited to your account as Roth. Just like an employee contribution made as Roth, an employer contribution made as Roth will be taxable in the year you receive the contribution. But the earnings and principal will generally be tax-free when you withdraw them in retirement.

Your employer may also make additional contributions for you, sometimes called non-elective or profit-sharing contributions. These contributions can change from year to year and are generally based on your pay, but they can also be based on your company's profits. And there is an overall limit on the combined contributions made by you and your employer of $70,000 for 2025.

How do 401(k) contributions affect my IRA contribution limit? If you're eligible to make 401(k) contributions—whether you do so or not—that may affect your personal and spouse's IRA deductions. You can still fully contribute to a traditional IRA, but your tax deduction will be based on your income. If you earn more than certain limits, you'll have no deduction available.

Although your pretax 401(k) contributions are tax deductible today, you'll eventually have to pay taxes on the money. It's important to be aware of your marginal tax bracket, because any 401(k) withdrawals that aren't rolled over into a qualified plan or IRA will be treated as ordinary taxable income.

Deciding whether to contribute to a traditional 401(k) for the tax "benefit" is often about your expectations for income during retirement. If you think you can live on less during retirement, deferring the taxes until you're in a lower tax bracket may make a lot of sense. If you expect to be in a higher tax bracket in retirement, then making Roth contributions could make more sense. Retirement professionals often say the important thing is to do something now. If you don't dedicate money to retirement now, you may need to invest even more in the future to make up for it.

Watch out for early withdrawals. In general, you're expected to wait until you reach age 59.5 before making any withdrawals from your 401(k). If you withdraw pretax money early, you'll have to pay taxes on the money at your regular marginal tax rate. Plus, you might be stuck with a 10% penalty from the IRS.

There are exceptions to the penalty on early withdrawals, such as if you leave your job at age 55 or older or if you have a disability. Not surprisingly, many investors wait to withdraw money until it can be done without risking a penalty.

The Roth 401(k) is just a 401(k) that allows after-tax Roth contributions. Until recently, Roth contributions could only made by employees—never as employer match or profit sharing. As discussed above, Roth employer contributions are now permitted, but it is up to each business to decide if this provision will be part of the retirement plan. If the 401(k) allows the employee Roth contributions, it's up to you to decide whether after-tax Roth or pretax traditional contributions are made. You can also do a combination of both types.

When you make Roth contributions to your 401(k), your money comes out after taxes. You won't see any tax savings in the year you make the contribution. But because you've already paid taxes on the money you contribute, when you withdraw money from a Roth account during retirement, it won't be taxed. Even after you reach retirement, you won't be taxed on the earnings in your Roth account. Any qualified withdrawal from the Roth account will be tax-free.

If you think you'll have a higher income in retirement than you do today, it might make sense to contribute to a Roth account—rather than making tax-deductible contributions. This will allow you to pay taxes on your Roth contribution today, potentially at a lower tax rate than if you delayed the taxes until later.

An additional advantage to higher income, folks, is that there's no income limit connected to 401(k) Roth contributions, so you won't see your ability to contribute phased out like it is in a Roth IRA.

Finally, remember that the limit on these employee Roth contributions is the same as the pretax employee contributions discussed above. If you make both pretax and Roth employee contributions in 2025, you get one $23,500 limit (or $31,000 if you're 50 or older).

The traditional 401(k) can potentially be a great tool to help you plan for the future in a tax-efficient manner. If your employer allows Roth employee contributions, this offers additional tax-planning benefits once you reach retirement and begin spending your nest egg. Due to the numerous alternatives available and the complexity of tax codes, we recommend consulting with a tax and/or financial professional to help you determine the most tax efficient way to participate and to withdraw assets in retirement.

Schwab does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances.

Maximum contribution limits cannot be exceeded. Contribution limits provided are based on federal law as stated in the Internal Revenue Code. Applicable state law may be different.