401(k) Rules for Income Tax Deductions

A 401(k) deduction may lower your income tax.

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A 401(k) account can provide tax benefits to business owners and employees. It allows employees to contribute to their retirement, with matching contributions from employers. Employees have contributions deducted from their taxable income, reducing their current tax liability. Employer matches are deductible as business expenses and business owners can also participate for personal tax deductions. There also are individual 401(k) plans for taxpayers who are self-employed or own their own businesses.

Contribution Limits

As of the date of publication, an employee can contribute up to 15 percent of total pay, to a maximum of $17,000. Those over age 50 are allowed another $5,500 as "catch up" contributions. Contributions are withheld from regular pay, just like income taxes, but are not included in calculations for taxable income. They do count as wages for Social Security, Medicare and unemployment taxes.

Roth Plans

A 401(k) also may be set up as a Roth plan, with contributions taxed at the time they are made. Since these contributions will count as taxable income, withdrawals from the 401(k) at retirement, typically after age 59 1/2, will be exempt from tax if the employee has had the Roth 401(k) for at least five years. Distributions from traditional 401(k) plans are subject to income tax at withdrawal.

Employer Matches

Employer matches for 401(k) plans are up to the business, but can be as much as 4 percent of an employee's pay. All company matches are fully deductible on the business' tax return. A small business owner can contribute to a 401(k) as an individual and also benefit from the business tax deduction for matching contributions to that plan.

Individual Plans

An individual 401(k) benefits self-employed taxpayers or small business owners with no full-time employees. An owner's spouse does not count as an employee. As of the date of publication, the individual contribution limits are the same, $17,000 or $22,500 if over age 50. However, the business can make a contribution up to 25 percent of the owner's compensation, up to a total of $50,000 for both personal and business contributions.

Withdrawal Rules

An employee can start taking money out of a traditional 401(k) without penalty at age 59 1/2. Distributions earlier than that are subject to a 10 percent penalty unless they qualify for an exception such as disability or first-time home purchase. Minimum withdrawals based on the fund amount and taxpayer's life expectancy must start at 70 1/2. A Roth plan 401(k) is basically exempt from these requirements because its contributions are made with money that's already been taxed.

401(k) Loans

A 401(k) also can be used for a personal loan up to $50,000. The limit is the amount of an employee's vested contributions, personal contributions plus vested matching or profit-sharing funds from an employer, up to that cap. Loans qualify for a low interest rate, but must be repaid in five years unless they are for a home, in which case the limit is 30 years. Money taken out as a loan will not earn interest or grow.