Do You Subtract 401k From Taxable Income?

A 401(k) plan is an employer-sponsored retirement savings account that offers tax advantages. Whether contributions reduce taxable income depends on the specific type of 401(k) plan chosen. Traditional and Roth 401(k)s have different tax treatments, impacting when and how taxes are paid on contributions and withdrawals. Understanding these distinctions is important for informed financial decisions.

How Traditional 401(k) Contributions Affect Taxable Income

Contributions to a Traditional 401(k) plan are made on a pre-tax basis, meaning these amounts are deducted from an employee’s gross income before federal income taxes are calculated. This directly lowers an individual’s current taxable income, resulting in immediate tax savings. For example, if an employee earns $70,000 and contributes $10,000, their federal taxable income would be reduced to $60,000.

Employers report these elective deferrals on the employee’s Form W-2. The amount contributed to a Traditional 401(k) is excluded from Box 1 (Wages, tips, other compensation), which reflects federal taxable wages. This means the employee does not need to claim a separate deduction on their tax return. While these contributions reduce federal taxable income, they are still subject to Social Security and Medicare taxes (FICA) and federal unemployment taxes (FUTA).

Funds within a Traditional 401(k) grow on a tax-deferred basis. Investment earnings are not taxed until they are withdrawn from the account in retirement. This compounding growth can boost the overall value of retirement savings over time. The tax liability is deferred until retirement, when the individual may be in a lower income tax bracket.

Understanding Roth 401(k) Tax Treatment

In contrast to Traditional 401(k)s, contributions to a Roth 401(k) are made on an after-tax basis. These contributions do not reduce an individual’s current taxable income, and the full amount of contributed wages is included in Box 1 of the employee’s W-2 form.

The primary benefit of a Roth 401(k) lies in the tax treatment of withdrawals during retirement. Qualified withdrawals are entirely tax-free, including both original contributions and any accumulated investment earnings. For a withdrawal to be considered qualified, two conditions must be met: the account holder must be at least 59½ years old, and the account must have been established for at least five years. The five-year period begins on January 1 of the year the first Roth contribution is made.

This tax-free growth and withdrawal feature can be advantageous for individuals who anticipate being in a higher tax bracket during their retirement years. Employer matching contributions to a Roth 401(k) are typically made on a pre-tax basis and are usually taxed upon withdrawal, similar to Traditional 401(k) distributions.

Annual Contribution Limits

The Internal Revenue Service (IRS) sets annual limits on the amounts individuals can contribute to their 401(k) plans. For 2025, employees can contribute up to $23,500 to their 401(k) accounts. This limit applies to the total employee contributions, whether they are made to a Traditional 401(k), a Roth 401(k), or a combination of both.

For individuals aged 50 and older, an additional “catch-up” contribution is permitted, allowing them to contribute more to their retirement savings. In 2025, the standard catch-up contribution limit for those 50 and over is $7,500. This means individuals aged 50 and older can contribute a total of $31,000 to their 401(k) plans in 2025. A higher catch-up contribution limit of $11,250 applies for those aged 60 to 63 in 2025, if their plan allows, bringing their total contribution ability to $34,750.

These limits apply per individual, even if they participate in multiple 401(k) plans through different employers. Employer contributions, such as matching contributions or profit-sharing, also count towards an overall plan limit, which for 2025 is $70,000 for combined employee and employer contributions.

Tax Implications of 401(k) Withdrawals

The tax treatment of 401(k) withdrawals depends on the plan type and distribution timing. For Traditional 401(k)s, all withdrawals, including pre-tax contributions and accumulated earnings, are taxed as ordinary income. This is because taxes were deferred on contributions and growth. Conversely, qualified withdrawals from a Roth 401(k) are tax-free. A qualified withdrawal typically requires the account to be open for at least five years and the account holder to be at least 59½ years old.

Withdrawals from either type of 401(k) before age 59½ are generally subject to a 10% early withdrawal penalty, in addition to being taxed as ordinary income (for Traditional 401(k)s or the earnings portion of non-qualified Roth 401(k) withdrawals). Exceptions to this penalty include withdrawals due to total and permanent disability, certain unreimbursed medical expenses, or separation from service at age 55 or older from the employer sponsoring the plan.