Most 401(k) contributions are pre-tax, which means the money comes out of your paycheck before income tax is calculated

When you contribute to a traditional 401(k), your employer deducts the money from your gross pay before calculating federal income tax, Social Security tax, and Medicare tax. That reduces your taxable income for the year. If you earn $60,000 and contribute $7,000 to a traditional 401(k), you only report $53,000 as taxable income on your tax return.

The trade-off is that you pay income tax on the money when you withdraw it in retirement. You also pay tax on any earnings the account accumulated over the years. This is the most common 401(k) setup, and it is what most employers offer by default.

Some employers also offer a Roth 401(k) option, which works the opposite way: contributions are post-tax, meaning you pay income tax on the money now, but withdrawals in retirement are tax-free. Not all employers offer this choice, so check your plan documents or ask your benefits administrator which options are available to you.

Key Takeaways

  • Traditional 401(k) contributions reduce your taxable income in the year you make them, lowering the income tax you owe that year.
  • You pay income tax on traditional 401(k) withdrawals and earnings when you take the money out in retirement.
  • Roth 401(k) contributions are made with after-tax dollars, but withdrawals and earnings are tax-free in retirement.
  • Your employer's plan documents or benefits summary will tell you whether you have a traditional 401(k), a Roth 401(k), or both options.
  • You can contribute to both a traditional and Roth 401(k) in the same year, but your total contributions across both cannot exceed the annual limit set by the IRS.

How pre-tax contributions lower your tax bill this year

Pre-tax 401(k) contributions reduce your adjusted gross income (AGI), which is the number the IRS uses to calculate how much tax you owe. The lower your AGI, the less federal income tax you pay. This is an when ready benefit in the year you make the contribution.

For example, if you are in the 22% federal tax bracket and contribute $500 per paycheck to a traditional 401(k), you save roughly $110 in federal income tax per paycheck (22% of $500). Over a year with 26 paychecks, that is about $2,860 in tax savings. Your take-home pay is reduced by $500 per paycheck, but your tax bill is reduced by more than that, so the net effect on your wallet is smaller than the contribution amount.

Pre-tax contributions also reduce your taxable income for state income tax purposes in most states, and they reduce the wages subject to Social Security and Medicare tax. This compounds the when ready tax savings.

How post-tax Roth contributions work differently

A Roth 401(k) contribution does not reduce your taxable income this year. You pay income tax on the full amount now, at your current tax rate. The advantage is that the money grows tax-free inside the account, and you owe no income tax on withdrawals or earnings when you retire.

Roth 401(k)s make sense if you expect to be in a higher tax bracket in retirement, or if you want to lock in today's tax rate and avoid uncertainty about future tax rates. They also give you more flexibility in retirement: you can withdraw your contributions (not earnings) penalty-free at any age without triggering a tax bill, whereas traditional 401(k) withdrawals before age 59½ usually incur a 10% penalty plus income tax.

Not all employers offer a Roth 401(k) option. If yours does, you will see it listed separately on your benefits enrollment form or in your plan documents. Some employers allow you to contribute to both a traditional and a Roth 401(k) in the same year, splitting your contributions between the two.

Understanding the difference on your pay stub

Your pay stub shows the breakdown of deductions from your paycheck. A traditional 401(k) contribution appears as a pre-tax deduction, meaning it is subtracted before the "Federal Income Tax Withheld" line is calculated. A Roth 401(k) contribution appears as a post-tax deduction, after federal income tax has already been withheld.

If you see your 401(k) contribution listed before the federal income tax line, it is pre-tax. If it appears after, it is post-tax. Your pay stub should label it clearly, but if you are unsure, ask your payroll or benefits department. They can tell you in seconds which type of 401(k) you are enrolled in.

What happens when you withdraw the money in retirement

With a traditional 401(k), every dollar you withdraw is taxed as ordinary income at your tax rate in that year. If you withdraw $50,000 from a traditional 401(k) and you are in the 22% tax bracket, you owe roughly $11,000 in federal income tax on that withdrawal, plus any state income tax that applies.

With a Roth 401(k), you withdraw your contributions and earnings tax-free. There is no tax bill, and the withdrawal does not increase your taxable income for the year. This can be a significant advantage if you expect to have substantial retirement income from other sources.

Both types of 401(k) require you to begin taking withdrawals at age 73 (as of 2023, under the find 2.0 Act). These are called required minimum distributions, or RMDs. With a traditional 401(k), RMDs are taxed as income. With a Roth 401(k), RMDs are not taxed, though you must still take them.

Choosing between pre-tax and post-tax when both are available

If your employer offers both a traditional and Roth 401(k), the choice depends on your current tax bracket and your expectations for retirement. If you are in a high tax bracket now and expect to be in a lower one in retirement, a traditional 401(k) makes sense: you save taxes at a high rate now and pay taxes at a lower rate later. If you are in a low tax bracket now and expect to be in a higher one later, a Roth 401(k) may be better.

Many people split contributions between both types to hedge their bets. You might contribute $10,000 to a traditional 401(k) and $5,000 to a Roth 401(k) in the same year, as long as your total does not exceed the IRS annual limit (which changes each year). Your benefits administrator can tell you the current limit and help you set up split contributions if your plan allows it.

If you are unsure which option fits your situation, consider speaking with a tax professional or financial advisor. They can review your income, tax bracket, and retirement goals and give you a recommendation based on your specific circumstances.

Frequently Asked Questions

Can I change from a traditional 401(k) to a Roth 401(k) mid-year?

Yes. You can change your election during the plan year, and the change takes effect on your next paycheck. Future contributions will go to the new account type, but money already in your traditional 401(k) stays there unless you do an in-plan Roth conversion, which is a separate transaction that may have tax consequences. Ask your benefits administrator about the process.

Do I pay Social Security and Medicare tax on 401(k) contributions?

No for traditional 401(k) contributions—they are exempt from Social Security and Medicare tax. Yes for Roth 401(k) contributions—you pay both taxes on the full amount, since Roth contributions are post-tax. This is one reason traditional 401(k)s provide an when ready tax advantage beyond just income tax.

What if I leave my job? Do I still owe tax on my 401(k)?

Not when ready. Your 401(k) stays in the account until you withdraw it. You can leave it there, roll it to an IRA, or roll it to your new employer's plan if they accept rollovers. You owe tax only when you withdraw the money. If you withdraw before age 59½, you typically owe a 10% penalty plus income tax on traditional 401(k) money.

Is there a limit to how much I can contribute to a 401(k)?

Yes. The IRS sets an annual contribution limit that changes each year. If you have both a traditional and Roth 401(k) at the same employer, your contributions to both combined cannot exceed this limit. Your benefits summary or payroll department can tell you the current limit and how much you have contributed so far this year.