How 401(k) Contributions Lower Your Taxable Income
 

401(k) contributions lower your taxable income through a mechanism known as tax deferral. When you make contributions to a traditional 401(k) plan, the amount you contribute is deducted from your taxable income for the year in which the contribution is made.
 

Here's how it works:
 

• Pre-tax Contributions: Contributions to a traditional 401(k) plan are typically made with pre-tax dollars, meaning the money you contribute is deducted from your gross income before income taxes are calculated. For example, if you earn $50,000 per year and contribute $5,000 to your 401(k), your taxable income for that year would be reduced to $45,000.

• Tax Savings: By reducing your taxable income, you effectively lower the amount of income tax you owe for the year. This can result in immediate tax savings, as you'll pay less in income taxes for the current year.

• Tax-deferred Growth: Additionally, any earnings on your 401(k) contributions grow tax-deferred until you withdraw them. This means you won't pay taxes on the investment gains as they accumulate, allowing your savings to potentially grow more quickly over time.

• Taxation Upon Withdrawal: However, it's important to note that while traditional, pretax contributions reduce your taxable income now, you will pay taxes on both the contributions and their earnings when you withdraw funds from your 401(k) in retirement. Withdrawals from traditional 401(k) plans are taxed as ordinary income at your applicable income tax rate in retirement.

Overall, by lowering your taxable income in the present and deferring taxes on investment earnings until retirement, 401(k) contributions can provide significant tax advantages and help individuals save more effectively for retirement.


The information contained herein is not intended as financial, legal or tax advice, and may not be suitable as required by specific circumstances. Please consult your financial planner, attorney and/or tax adviser as needed.