How Do 401(k) Tax Deductions Work?

Learn About the Benefits of Saving for Retirement in a Pre-Tax 401(k)

Image shows a check for 2,000 for John Doe, made out from Dennis Associates on August 28, 2019. Text reads:

Image by Katie Kerpel © The Balance 2019

401(k) plans were first established by Congress to encourage workers to save for retirement. Besides accumulating money for achieving financial independence in retirement down the road, traditional 401(k) plans offer significant tax benefits for today.

The amount of your 401(k) contributions directly reduces your taxable income since contributions are typically pre-tax. As a result, this means you'll pay taxes on less income overall. Exceptions include Roth 401(k) and other after-tax 401(k) contributions.

Because pre-tax contributions reduce taxable income and you pay less tax overall, your take-home pay will not be reduced by the full amount of your contribution. In other words, once you determine the amount you're able to save in income taxes, you'll often discover that the contributions cost you less than you would have expected.

Let's look at a few different scenarios to get a better understanding of how it all works.

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

Even though this person contributes $187.50 per paycheck, their paycheck is only reduced by $165 because they're paying tax on less income. The $22.50 difference represents the pre-tax savings. (Note: Actual pre-tax savings may be greater if 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

Even though this person contributes $375.00 per paycheck, their paycheck is only reduced by $308.34 because they're paying tax on less income. The $66.66 difference represents the pre-tax savings. (Note: Actual pre-tax savings may 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 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

Even though this person contributes $333 per paycheck, their paycheck is only $293.30 smaller because they're paying tax on less income. The $39.70 difference represents the pre-tax savings. (Note: Actual pre-tax savings may be greater if subject to state or local income taxes).

Understanding Your Marginal Tax Bracket

The tax savings becomes more significant when you're in a higher marginal income tax bracket. Recent tax law changes make it important to review how much you're benefiting from deducting your 401(k) contributions. If you enjoy getting those tax savings today and anticipate being at the same or a lower tax bracket during your retirement years, you should continue making pre-tax contributions to a 401(k) plan. However, if you anticipate being in a higher tax bracket or prefer the idea of tax-free growth of earnings, you may prefer making contributions to a Roth 401(k).

Other Ways to Reduce Taxable Income

Exactly how much you will pay in Federal income taxes is based on your taxable income. If you decrease your taxable income, you decrease the amount of tax you pay. 

There are a few financial planning strategies you can use to reduce your taxable income. Beyond contributing to traditional 401(k) plan, some common strategies include setting aside funds to pay for health related expenses in an HSA or FSA, paying for child care expenses with a Dependent Care FSA, pre-tax insurance premiums, and saving in a deductible IRA.