How Does a Pre-Tax 401(k) Work?

The Tax Benefits of Saving for Retirement in a Pre-Tax 401(k)

How Do 401(k) Tax Deductions Work?

The Balance / Katie Kerpel

401(k) plans were first established by Congress to encourage and help workers to save for retirement. Traditional 401(k) plans offer significant tax benefits at the time when you're making contributions, in addition to accumulating money for achieving financial independence later down the road in retirement.

How 401(k) Deductions Work

Your 401(k) contributions directly reduce your taxable income at the time you make them because they're typically made with pre-tax dollars. You'll pay taxes on less income overall as a result.

Exceptions exist for Roth 401(k) and other after-tax 401(k) contributions.

Your take-home pay won't be reduced by the full amount of your contributions. They're made before withholding is calculated based on what remains after you've made them. These pre-tax contributions reduce your taxable income and you pay less tax overall.

You'll often discover that the contributions cost you less than you would have expected when you determine the amount you're able to save in income taxes.

Your contributions to a 401(k) aren't taxed until you withdrawal them in retirement, and your employer can contribute to your plan as well.

401(k) Deduction Scenario 1

Here's an example of how pre-tax deductions work for a single person with a $45,000 salary contributing 10% of their gross salary: 

Gross pay if paid twice per month ($45,000 per year): $1,875
Net pay if paid twice per month without a 401(k) contribution: $1,559.43
Net pay if paid twice per month WITH a $375 401(k) contribution: $1,394.43
Difference: $165
Pre-tax savings:  $22.50

This individual contributes $187.50 per paycheck, but their paycheck is only reduced by $165 because they're paying tax on less income. The $22.50 difference represents the pre-tax savings.

Actual pre-tax savings might be greater if earnings are subject to state or local income taxes.

401(k) Deduction Scenario 2

Here's a similar example of a single person with a $90,000 salary contributing 10% of their gross salary: 

Gross pay if paid twice per month ($90,000 per year): $3,750
Net pay if paid twice per month without a 401(k) contribution: $3,044.33
Net pay if paid twice per month WITH a $375 401(k) contribution: $2,753.99
Difference: $308.34
Pre-tax savings:  $66.66

This individual's paycheck is only reduced by $308.34, even though they contributes $375.00, because they're paying tax on less income. The $66.66 difference represents the pre-tax savings. Actual pre-tax savings might be greater if subject to state or local income taxes.

401(k) Deduction Scenario 3

Here’s another example for a married individual with a $80,000 salary who is also contributing 10% to a 401(k) and claiming zero allowances on Form W-4:

Gross pay if paid twice per month ($80,000 per year): $3,333
Net pay if paid twice per month without a 401(k) contribution: $2,825.31
Net pay if paid twice per month WITH a $333.30 401(k) contribution: $2,532.01
Difference: $293.30
Pre-tax savings:  $39.70

This person contributes $333 per paycheck, but their paycheck is only $293.30 less because they're paying tax on less income. The $39.70 difference represents pre-tax savings. Again, actual pre-tax savings may be greater if subject to state or local income taxes.

Your Marginal Tax Bracket

Your tax savings become more significant when you're in a higher marginal income tax bracket.

Your marginal tax rate is the rate you'll pay on your highest dollar of income.

Your tax brackets as a single taxpayer as of the 2021 tax year would be:

  • 10%: On income from $0 to $9,950
  • 12%: On income from $9,951 to $40,525
  • 22%: On income from $40,526 to $86,375
  • 24%: On income from $86,376 to $164,925
  • 32%: On income from $164,926 to $209,425
  • 35%: On income from $209,426 to $523,600
  • 37%: On income over $523,600

Your marginal tax rate would therefore be 22% in 2021 if you earn $80,000 because your top dollar falls within this parameter.

Tax brackets cover different spans of income if you're married and filing a joint return or if you qualify as head of household because you're single, have a dependent, and meet other rules.

You should continue making pre-tax contributions to a 401(k) plan if you enjoy getting those tax savings because you're in a higher tax bracket, and you anticipate being at a lower marginal tax bracket during your retirement years. You might prefer making contributions to a Roth 401(k) if you anticipate being in a higher tax bracket when you retire, or if you prefer the idea of tax-free growth of earnings.

Other Ways to Reduce Taxable Income

Exactly how much you'll pay in federal income taxes is based on your taxable income. You decrease the amount of tax you pay when you decrease your taxable income.

You can use a few financial planning strategies to reduce your taxable income. Some common strategies beyond contributing to a 401(k) include setting aside funds to pay for health-related expenses in a health savings account or a flexible spending account. You might also consider paying for child care expenses with a dependent care FSA and saving in a deductible IRA.

NOTE: The Balance does not provide tax or investment advice or financial services. The information presented here is without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Always consult with an experienced retirement or financial planner.