A 401(k) is usually pre-tax, meaning you contribute money before income tax is taken out

When you put money into a standard 401(k), your employer deducts it from your paycheck before calculating federal income tax. That means your taxable income for the year goes down by the amount you contributed. If you earn $60,000 and contribute $7,000 to a pre-tax 401(k), you only report $53,000 as taxable income to the IRS.

You pay income tax on that money later, when you withdraw it in retirement. At that point, the withdrawals count as ordinary income and are taxed at whatever your tax rate is then. You also do not pay Social Security or Medicare tax (called FICA) on pre-tax 401(k) contributions, which saves you an additional 7.65 percent right away.

Some employers also offer a Roth 401(k) option, which works the opposite way: you contribute after-tax dollars, pay income tax on the money now, and then withdraw it tax-free in retirement. Not all employers offer both, so check your plan documents or ask your benefits administrator which options are available to you.

Key Takeaways

  • A standard 401(k) is pre-tax, so contributions lower your taxable income in the year you make them.
  • You pay federal income tax on pre-tax 401(k) withdrawals when you take the money out in retirement, not when you contribute.
  • Pre-tax contributions also skip Social Security and Medicare tax, saving you 7.65 percent when ready.
  • A Roth 401(k) is the opposite: you pay tax now and withdraw tax-free later, but not all employers offer it.
  • Your employer's plan documents or benefits team can tell you which type or types your workplace offers.

How pre-tax contributions reduce your tax bill right now

The when ready tax savings from a pre-tax 401(k) come from lowering your adjusted gross income (AGI). The IRS uses your AGI to determine your tax bracket, which affects how much federal income tax you owe. When you contribute to a pre-tax 401(k), that money never appears on your W-2 as wages, so it does not count toward your AGI.

The savings are real but depend on your tax bracket. If you are in the 22 percent federal tax bracket and contribute $500 to a pre-tax 401(k), you save $110 in federal income tax that year. You also save roughly $38 in FICA tax (7.65 percent of $500). That $500 contribution costs you only about $352 out of pocket because the rest comes from taxes you would have paid anyway.

This is why pre-tax 401(k)s are often called a tax deferral rather than tax avoidance: you are not avoiding the tax, you are postponing it until you withdraw the money in retirement.

What happens when you withdraw money in retirement

When you reach age 59½ and start taking withdrawals from a pre-tax 401(k), each dollar you withdraw is taxed as ordinary income at your tax rate that year. If you withdraw $40,000 in a year when your tax bracket is 24 percent, you owe $9,600 in federal income tax on that withdrawal. You also owe state income tax in most states.

The amount of tax you pay depends on your total income that year, not on what you contributed years earlier. If you have other income sources in retirement—Social Security, a pension, rental income, or part-time work—those all count toward your income and can push you into a higher tax bracket. This is why some people end up paying more tax in retirement than they saved by contributing pre-tax.

You must start taking withdrawals at age 73 (as of 2023; this age changes under current law). The IRS calls these required minimum distributions (RMDs), and you have to include them in your taxable income whether you need the money or not.

Roth 401(k)s: paying tax now instead of later

A Roth 401(k) lets you flip the timing. You contribute after-tax dollars—meaning the money comes out of your paycheck after income tax is already taken out—and then you pay no federal income tax on withdrawals in retirement. The growth inside the account is also tax-free.

A Roth 401(k) makes sense if you expect to be in a higher tax bracket in retirement than you are now, or if you want to reduce your taxable income in retirement to stay below a threshold that affects Medicare premiums or Social Security taxation. It also has no required minimum distributions during your lifetime, so you can leave the money untouched longer if you do not need it.

The downside is that you get no tax break today. If you contribute $7,000 to a Roth 401(k), you pay income tax on that $7,000 now, and it costs you the full $7,000 out of pocket (plus the tax on it). You have to be confident you will stay in the account long enough to make up for that upfront cost.

Can you have both pre-tax and Roth in the same plan?

Many employers allow you to split your contributions between a pre-tax 401(k) and a Roth 401(k) in the same year. You might contribute $3,000 pre-tax and $4,000 Roth, for example. The total of both cannot exceed the annual contribution limit set by the IRS (currently $23,500 for people under 50, or $31,000 if you are 50 or older).

Splitting contributions can be a middle-ground strategy: you get some tax savings now from the pre-tax portion, and some tax-free growth later from the Roth portion. This approach works best if you are unsure whether your tax bracket will be higher or lower in retirement.

Your employer's plan may not offer both options. Some small employers offer only pre-tax, and a few offer only Roth. Check your plan summary or benefits website to see what your workplace provides.

How employer matching works with pre-tax and Roth contributions

If your employer matches your 401(k) contributions, the match always goes into a pre-tax account, even if you contribute to a Roth 401(k). This is an IRS rule, not a choice. So if you contribute $5,000 to a Roth 401(k) and your employer matches 50 percent, your employer's $2,500 match lands in a pre-tax 401(k) bucket within the same plan.

When you withdraw in retirement, you will owe tax on the employer match portion no matter what, because it was never taxed when you earned it. Only your own Roth contributions come out tax-free. This is why the Roth 401(k) is less powerful than a Roth IRA for some people: the employer match ruins the all-tax-free withdrawal benefit.

Frequently Asked Questions

Can I change from pre-tax to Roth or vice versa?

You can change your contribution type for future paychecks at any time during the year, usually through your employer's benefits portal or by contacting payroll. You cannot retroactively change contributions you have already made. Some plans allow you to convert existing pre-tax 401(k) money to Roth, but you pay income tax on the amount converted in that year.

What is the difference between a 401(k) and a traditional IRA?

Both are pre-tax retirement accounts, but a 401(k) is through your employer and has higher contribution limits ($23,500 versus $7,000 for an IRA in 2024). A 401(k) may offer employer matching, which an IRA does not. IRAs have income limits for pre-tax contributions if you have access to a 401(k) at work, but 401(k)s do not.

Do I pay taxes twice on a pre-tax 401(k)?

No. You defer tax when you contribute, then pay it once when you withdraw. You do not pay tax on the growth inside the account. The money you withdraw is taxed as ordinary income, not as capital gains.

What happens to my 401(k) if I leave my job?

You keep the money and can roll it into an IRA or into your new employer's 401(k) plan without paying tax or penalties. If you withdraw it directly, you owe income tax plus a 10 percent penalty if you are under 59½. Your old employer's plan documents explain your rollover options.

Is a 401(k) better than a Roth IRA?

Neither is universally better. A 401(k) gives you an when ready tax break and may include employer matching. A Roth IRA offers tax-free growth and withdrawals, no required distributions, and more investment choices. If your employer matches, the 401(k) is usually the better starting point because the match is information programs.