If you put money into a 401(k) account at work, that money typically isn't taxed until you withdraw it from the account. The tax break usually comes immediately as the money is taken out of your paycheck, so you don't have to wait for tax time to get the money back, which is better than the typical above-the-line tax deduction. You can deduct retirement contributions to 401(k), IRA and other accounts whether or not you itemize your deductions on your taxes.
401(k) contributions don't quite work the same as other tax deductions, but they're similar to above-the-line deductions because you don't need to itemize your deductions to claim them.
401(k) and the Standard Deduction
A 401(k) plan is a type of retirement account that you can set up through your employer. Typically, it allows you to save money by automatically contributing a portion of each paycheck without having to pay tax on it. Instead, you pay tax on money you withdraw from the account once you are retired.
People often divide tax deductions into above-the-line and below-the-line deductions. This is based on where the deductions are noted on the 1040 tax form, but it also refers to another distinction: above-the-line deductions are those that offset your income even if you take the standard deduction. Below-the-line deductions can only be claimed if you itemize your deductions.
A 401(k) contribution works somewhat similar to an above-the-line deduction, but it's slightly different, because you don't have to wait to file your tax return to see the tax benefits. Instead, your tax withholdings are automatically adjusted for each paycheck where you contribute to the account. For a traditional IRA, the money you contribute is deductible from your taxes as an above-the-line deduction. Roth accounts, which allow your investments to grow tax-free but don't give you an upfront deduction, don't see contributions deductible at all.
Remember that some laws around tax deductions changed as of tax year 2018, although the rules around 401(k) and IRA accounts remain largely unchanged. If you're looking for information on what's deductible or a standard deduction calculator for 2018 or a later year, make sure you're using information that takes into account the current tax laws.
401(k) Tax Deduction Limit
You can choose how much you want to contribute to your 401(k), but you can't go over annual contribution limits imposed by the Internal Revenue Service.
For tax year 2019, the year for which you'll file taxes in 2020, that's $19,000. If you're 50 years old or older, you can contribute an additional $6,000 per year.
Other retirement accounts have their own annual contribution limits. For example, you can contribute up to $6,000 per year as of 2019 to IRAs. If you're age 50 or older, you can contribute up to $6,500.
Paying Taxes on Withdrawals
While you don't pay tax on the money you put into a 401(k) or an IRA, you do pay tax on your withdrawals. That's because the accounts are designed to defer taxes during your working years, not negate them entirely. It's still a good deal for many working people, since they can effectively pay tax at a lower income tax bracket after retiring and not pay those taxes during their working years.
If you withdraw money from retirement accounts before you reach age 59 1/2, you will typically owe an additional 10 percent penalty tax to the IRS as well as the typical tax on the withdrawn funds. Certain exceptions for hardship situations do apply.
Once you reach age 70 1/2, you must begin withdrawing money from your retirement accounts, including traditional IRAs and 401(k)s. The amount you must withdraw every year, known as a required minimum distribution, is determined by the IRS using your age and the amount of money in the accounts. If you don't make the required withdrawals, you will face a hefty tax penalty that's typically more than the tax you would pay on the withdrawal. Roth accounts aren't subject to required minimum distributions.
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.