When you receive your paycheck, chances are the amount you get to deposit in your bank account is smaller than the total amount you earned. This is because your employer withholds money from each check for various payroll deductions, including tax withholding and contributions to employer-sponsored retirement plans, like a 401(k). Your contributions will show up in the "deductions" section of your pay stub so you can see how much money you're contributing.
401(k) Pretax Contributions
Contributions to a pretax, or traditional, 401(k) plan come out of your paycheck before determining how much of your income is subject to federal income taxes. Your 401(k) contributions are voluntary, which means you can increase or decrease your contributions at any time. Contributing to a traditional 401(k) plan is an option for everyone because the IRS does not restrict your contributions based on your income, so everyone who works for a company that offers a 401(k) plan can take advantage of the tax breaks.
Even though everyone can contribute to a traditional 401(k) plan, the IRS does cap how much you can contribute each year. As of 2015, you can contribute a maximum of $18,000 to your traditional 401(k) plan, but the total of your contributions plus contributions made by your employer can't exceed $53,000. If you're over 55, you can also put in an extra $6,000 per year, boosting the limits to $24,000 for contributions you make and $59,000 for contributions made by both you and your employer.
Tax Impact of Contributions
Each dollar that you contribute to your 401(k) plan reduces your taxable income for the year. However, you don't claim it as a deduction on your income tax return. Instead, the amount of your contributions reduces the amount of taxable income that shows up on your W-2, which means it never gets reported as taxable income to begin with. For example, say your salary is $70,000, but you contribute $5,000 to your 401(k) plan. When you receive your W-2 at the end of the year, it will show only $65,000 of taxable income and $5,000 of 401(k) contributions.
Traditional IRA Deduction Limits
If you have the ability to contribute to a 401(k) plan during the year, you're not allowed to deduct your contributions to a traditional IRA if your income is too high. The income limits vary each year with inflation and depending on your filing status. For example, in 2015, if you're covered by a 401(k) plan, you can't deduct any of your traditional IRA contributions if you're single and your income exceeds $71,000 or married filing jointly and your income exceeds $118,000.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."