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A traditional 401(k) offers a way to reduce your taxable income now and save for retirement. However, you can't deduct the money on your tax return. Your 401(k) contributions were handled through your employer, which means any tax deductions were already taken on your paycheck.
Savings on Taxes Now
It can be confusing when you hear that contributing to a 401(k) will reduce your taxes now. That's still true for traditional 401(k)s. The contributions you make in those accounts reduce your taxable income, which reduces how much taxes are taken out of your paycheck. At the end of the year, your taxable income, reduced by the amount contributed throughout the year, is reflected in your W-2 statement. If your company matches any of your contributions, that money isn't included in your taxable income for the year, either.
Roth 401(k) Accounts
While traditional 401(k) accounts take your contributions out of your pay before taxes, a Roth 401(k) uses after-tax dollars. Roth contributions come off your take-home pay after other deductions are made. This doesn't affect your taxes or taxable income. The top advantage of a Roth 401(k) is your contributions won't be taxed again. A disadvantage is that employer contributions aren't allowed directly in a Roth 401(k).
The Internal Revenue Service sets a yearly limit on pretax 401(k) contributions. As of 2013, the limit is $17,500, or $23,000 if you are age 50 or over. These limits are the most your can reduce your taxable income by using a 401(k). They don't include employer contributions. There is no limit to the amount you can save in a Roth 401(k).
Taxman Will Come
If the future, when you are looking at your traditional 401(k) balance and figuring if you've saved enough for retirement, remember the taxman is waiting. When you start taking money out of your traditional 401(k) in the future, it will be taxed as income. The contributions from your employers and all of your investment earnings through the years will be, too.
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