How Do 401k Pretax Contributions Work?
Understand how a pretax 401k contribution affects your current paycheck and how those deferred funds are managed and taxed through retirement.
A 401(k) is an employer-sponsored retirement savings account that allows you to contribute a portion of your wages. A primary method for funding these accounts is through pretax contributions, which involves investing money before it is subject to income tax. This approach has specific rules and implications for your current taxes and future retirement income.
The Mechanics of Pretax Contributions
When you make pretax 401(k) contributions, your employer deducts the amount from your gross pay before federal and most state income taxes are calculated. This lowers your reported income for the pay period, which reduces the amount of income tax you owe for the year.
For example, an employee who earns a gross salary of $2,000 per paycheck and decides to contribute 5% to their traditional 401(k) has a $100 contribution sent directly to the retirement account. Consequently, the employee’s taxable income for that pay period is reduced from $2,000 to $1,900. Income tax withholding is then calculated based on this lower amount.
This process provides an immediate tax deferral, meaning you do not pay taxes on the contributed funds or their investment earnings until you withdraw them. This stands in contrast to Roth 401(k) contributions, which are made with post-tax dollars. With a Roth option, your contribution does not lower your current taxable income, but qualified withdrawals in retirement are tax-free.
Contribution Limits and Employer Matching
The Internal Revenue Service (IRS) sets annual limits on the amount an employee can contribute to their 401(k). For 2025, the maximum employee contribution is $23,500. This limit applies to the total of your elective deferrals, which includes both pretax and Roth contributions if your plan offers both.
Employees who are age 50 or over can make additional “catch-up” contributions. For 2025, the standard catch-up limit is $7,500. For those aged 60, 61, 62, and 63, the catch-up limit is increased to $11,250.
Many employers offer a matching contribution as an incentive for employees to save. For example, an employer might match 50 cents for every dollar an employee contributes, up to a certain percentage of their salary. These employer contributions are made on a pretax basis, meaning the money will be taxed as ordinary income when you withdraw it. Some plans may also allow employers to make matching contributions on a Roth (post-tax) basis.
Taxation During Retirement and Early Withdrawals
When you begin taking money out of your pretax 401(k), the tax deferral ends. All distributions from a traditional 401(k) are taxed as ordinary income in the year the withdrawal is made. This includes your original contributions and any investment earnings the account has generated. The tax treatment is based on the assumption that you will likely be in a lower tax bracket during retirement than in your peak earning years.
You are required to begin taking withdrawals at a certain point. These are known as Required Minimum Distributions (RMDs), and they must begin once you reach age 73. The RMD amount is calculated annually based on your account balance and life expectancy, and failure to take the required distribution can result in significant tax penalties.
Withdrawing funds before reaching age 59½ triggers an additional 10% tax on top of the regular income tax. This early withdrawal penalty is designed to discourage using retirement funds for non-retirement purposes. However, the IRS allows for several exceptions to this penalty, including:
- Total and permanent disability
- Certain qualifying medical expenses
- Distributions made to a beneficiary after the account holder’s death
- Distributions for a qualified birth or adoption (up to $5,000)
- For victims of domestic abuse (up to the lesser of $10,000 or 50% of the account value)
- For certain emergency personal expenses (up to $1,000 annually)
Rollover and Plan Separation Options
Upon leaving an employer, you have several options for managing the funds in your 401(k) account. One choice is to leave the money in your former employer’s plan, provided the plan rules and your account balance meet the requirements. However, you will be subject to the investment choices and rules of that plan.
A more common action is to initiate a rollover, which moves your funds from one retirement account to another without triggering immediate taxation. You can execute a direct rollover into a 401(k) plan at a new employer, consolidating your retirement savings in one place.
Another frequent choice is to roll the funds into a Traditional Individual Retirement Arrangement (IRA), which gives you a broader range of investment options than most 401(k) plans. During a rollover, you also have the option to convert the pretax funds into a Roth IRA. This is a taxable event, and the entire amount you convert is considered ordinary income for that year.