Using a 401(k) plan to save for retirement allows you to lower your income taxes and supercharge your retirement investments because the money grows tax-sheltered as long as it remains in the account. However, income taxes and FICA taxes are applied differently to different types of income. Though the 401(k) contributions are not hit with income taxes, some are still subject to FICA taxes. Knowing which types of 401(k) contributions are subject to which types of taxes helps you better budget each paycheck.
You are required to pay FICA tax on all contributions you make to your 401(k) plan. However, if your employer makes contributions to your 401(k), these funds are not subject to FICA tax.
FICA Taxes Explained
FICA taxes are the taxes imposed on your employee income. FICA taxes include the Social Security tax and the Medicare tax. Each tax is split equally between the employee and the company. The Social Security tax is 12.4 percent, so 6.2 percent is taken out of your paycheck and your employer pays an additional 6.2 percent. The Medicare tax is 2.9 percent, so 1.45 percent comes out of your paycheck and the remaining 1.45 percent is paid by your employer.
The Medicare tax applies to all of your wages, regardless of how much money you make. The Social Security tax, on the other hand, only applies to the amount of the Social Security wage base. For 2018, the Social Security wage base is $128,400, up from $127,200 in 2017. Any earned income in excess of that amount is only hit with the Medicare tax, but not the Social Security tax. For example, if your salary is $130,000 in 2018, the first $128,400 is subject to both the Social Security and the Medicare tax, but the last $1,600 is subject only to the much smaller Medicare tax.
Contributions You Make
You continue to pay FICA taxes on the contributions you make to your 401(k) plan. As a result, when you designate a portion of your paycheck to be added to your 401(k) plan, your take home pay is still reduced by the contribution amount plus FICA taxes. For example, if you contribute $500 to your 401(k) plan during a pay period, you still have $38.25 withheld for FICA taxes, even though you don’t pay income taxes on your 401(k) contribution. But, if your income is already in excess of the Social Security tax wage base, your 401(k) contribution is only hit with the Medicare tax.
Contributions Your Employer Makes
Contributions your employer makes to your 401(k) plan, on the other hand, are not subject to FICA taxes. Many employers offer a matching contribution or will automatically contribute to your 401(k) plan on your behalf. For example, if your employer adds $500 to your 401(k) plan on your behalf, that entire $500 gets added to your 401(k) plan and you won’t see any additional amounts withheld from your paycheck because it isn’t subject to income taxes or FICA taxes.
When you receive your W-2 at the end of the year, your 401(k) contributions won’t be included in box 1, which is your total income subject to income taxes for the year. However, the amounts show in box 3 and box 5, the amounts subject to Social Security taxes and Medicare taxes, respectively, will still include your 401(k) contributions because those are subject to FICA taxes.
- IRS: Are Retirement Plan Contributions Subject to Wthholding for FICA, Medicare or Federal Income Tax?
- Social Security Administration: Social Security & Medicare Tax Rates
- Social Security Administration: Contribution and Benefit Base
- IRS: Form W-2 Instructions
- Social Security Administration. "What Are FICA and SECA Taxes?" Accessed April 1, 2020.
- Social Security Administration. "2021 SOCIAL SECURITY CHANGES." Accessed Oct. 15, 2020.
- Internal Revenue Service. "Topic No. 751 Social Security and Medicare Withholding Rates." Accessed Nov. 5, 2020.
- Social Security Administration. "Supplemental Security Income Overview." Accessed April 1, 2020.
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."