Knowing how taxes affect your retirement contributions helps you to decide which plan is right for you. Traditional, safe harbor and SIMPLE 401(k) plans allow you to make contributions with pretax money; however, a Roth 401(k) plan lets you pay with after-tax money. In some cases, pretax 401(k) plans lower taxable income. After-tax plans do not reduce taxable income.
Your contributions to a pretax 401(k) plan reduce your taxable wages for federal income tax purposes. Your employer subtracts your contributions from your gross wages before withholding the tax. Your contributions, however, do not reduce your taxable wages for Social Security tax and Medicare tax purposes; your employer must deduct those two taxes from your contributions. In most cases, pretax contributions are excluded from state and local income taxes; however, consult with the state revenue agency for clarification, as there may be exceptions. For example, the state of Pennsylvania and the city of Pittsburgh both count 401(k) contributions as taxable for state and local income tax purposes.
Your contributions to an after-tax 401(k) plan, such as a Roth 401(k), are subject to federal and applicable state and local income tax and Social Security and Medicare taxes at the time of withholding.
Pretax contributions reduce the amount in Box 1 of your annual W-2 form, because that box includes only your taxable wages for federal income tax purposes. Pretax contributions do not reduce the amounts in boxes 3 and 5 – specifically, your Social Security and Medicare wages -- because your contributions are not excluded from Social Security and Medicare taxes. Whether your contributions reduce the state and local amounts, respectively, in boxes 16 and 18 depends on the whether the state and local governments regard 401(k) contributions as taxable. If you paid your contributions with after-tax money, they’re included in your taxable wages in boxes 1, 3, 5, and, if applicable, 16 and 18.
You cannot take a deduction for pretax contributions on your tax return because you already received a tax break at the time of withholding. You also do not receive a tax deduction on your Roth 401(k) contributions, as when you withdraw from the plan, you will not owe any income taxes on your withdrawals.
Pretax Versus After-tax
With a pretax plan, when you withdraw your money you will owe income taxes on the withdrawals -- in other words, both on the contributions you put in and on your investment gains. With an after-tax plan, provided the distribution is a qualified one, you will not owe any income taxes on your contributions and gains when you withdraw from the plan. With both plans, if your employer matches your contributions, the match amount is subject to taxation at the time of withdrawal. The upside of a pretax plan is that it gives you more take-home pay than an after-tax plan; however, if you foresee yourself falling into a higher tax bracket when you withdraw your money, an after-tax plan might be better.
- IRS.gov: 401(k) Resource Guide - Plan Participants - 401(k) Plan Overview
- Pennsylvania Department of Revenue: Are My Contributions to a 401(k) Plan Excluded From Employer Withholding?
- Pittsburgh Department of Finance: FAQ - Business and Wage Tax
- IRS.gov: W-2 Form
- TurboTax: Can You Deduct 401K Savings From Your Taxes?
- IRS.gov: Designated Roth Accounts
- SmartMoney: Understanding the Roth 401(k)
Grace Ferguson has been writing professionally since 2009. With 10 years of experience in employee benefits and payroll administration, Ferguson has written extensively on topics relating to employment and finance. A research writer as well, she has been published in The Sage Encyclopedia and Mission Bell Media.