401(k) Tax "Deduction": What You Need to Know

There's a good chance that when you signed up for your employer's retirement plan you signed up for a traditional 401(k). If this is the case, you're probably receiving a 401(k) tax benefit that reduces your taxable income.

If you're wondering how a 401(k) plan works to reduce your taxes while also helping you save for retirement, here are some details you need to know.

A pre-tax 401(k) contribution isn't really a true tax deduction because the money does not appear on your tax return. Instead, the funds are taken directly out of your paycheck, which lowers the income reported on your W-2. But in the end, pre-tax 401(k) contributions have the same effect as a tax deduction, and it's easier on you because you never have to report this money on your tax return.

Here's a simple example. Let's say you're single, and after taking the standard deduction, your taxable income is $85,000 per year. This puts you in the 22% tax bracket. You can get a back-of-the-envelope estimate for how much a tax-deductible contribution to your 401(k) would save you in taxes by multiplying your contribution by your tax bracket. So, if you contributed $20,000 to your 401(k), you might see a tax savings of $4,400. This isn't a fool-proof method, and your actual savings would vary based on state and local income taxes and other factors.

Putting that extra money aside now in a retirement plan—rather than paying it in taxes—can be a way to compound your potential returns over time. Yes, you'll be taxed eventually when you withdraw money. But by then, you might have a smaller retirement income and be in a lower tax bracket. So, when you do finally pay taxes, there's a chance the tax bill will be lower than if you'd paid taxes on the money today.

As an employee, there are limits on how much you can contribute to a 401(k) each year. The Internal Revenue Service (IRS) updates that information each year based on inflation and other factors. For 2026, the employee contribution limit is $24,500. For those 50 and older, it's possible to make an additional catch-up contribution of $8,000 for a total of $32,500 in 2026. For those 60 to 63, the SECURE 2.0 ACT introduced a super, or higher, catch-up contribution of $11,250 in 2026.

Beyond the normal limits, there is also an overall limit on the combined contributions made to a 401(k) of $72,000 for 2026. For those over age 50, the overall limit is $80,000 and for those age 60 to 63, the overall limit is $83,250. This limit includes contributions by both you and your employer.

Each of the limits above cover contributions across all 401(k) accounts. Which means, if you have two jobs, your 401(k) limits don't double. In addition, these limits take into account any type of contribution to a 401(k), whether to a tax-deferred plan, to a Roth account, or with after-tax dollars.

Assuming your retirement plan offers both options, you can generally choose whether you want your catch-up contributions to be pre-tax (to a traditional 401(k) account) or after-tax (to a Roth account). However, if you're a high-income earner, beginning in 2026 you'll have to make all catch-up contributions to a Roth account.

The tax rules define a high-income earner as anyone who made more than $150,000 in FICA wages in the prior year. Those making $150,000 or less in the prior year can continue making catch-up contributions to their regular pre-tax account.

With a 401(k), you need to make your contributions during the calendar year. So, if you want time to boost your retirement account and benefit from the special tax treatment, you need to get that extra money into your account before year end. (In contrast, you have until Tax Day to make tax-deductible IRA contributions for the tax year.)

If your employer offers a matching contribution, it generally doesn't affect your own normal contribution limits. However, it does count toward the overall limit. If your employer's contributions are pre-tax, that additional money also won't be taxable. But, because the contributions go into your retirement account, you'll have to pay taxes on the money when you withdraw funds down the line.

Though most employer contributions are pre-tax, that's may not always be the case. The SECURE 2.0 Act permits employers to make their matching contributions to a Roth account. Just like an employee contribution made as Roth, an employer contribution made as Roth will be taxable in the year you receive the contribution. But the earnings and principal will generally be tax-free when you withdraw them later on, as long as the account has been open for 5 tax years since your first contribution to the plan and you are 59½ or older.

Your employer may also make additional contributions for you, sometimes called non-elective or profit-sharing contributions. These contributions can change from year to year and are generally based on your pay, but they can also be based on your company's profits.

If you're eligible to contribute to a 401(k) (even if you don't contribute), it could impact IRA deductions for you and your spouse. You can still fully contribute to a traditional IRA, but your tax deduction might be reduced based on your income. And if you earn more than certain limits, you may not be able to deduct any of your IRA contributions from your taxes.

Also, it's important to know that contribution limits for a 401(k) and for IRAs are separate and independent. Even if you make the maximum contribution to your 401(k) in 2026, you can still contribute a maximum of $7,500 to traditional or Roth IRAs (plus a $1,100 catch-up contribution if over age 50), but be aware of income limits that restrict who can make contributions to Roth IRAs. Also, that limit applies to both Roth and traditional IRAs, not each individually.

Although your pre-tax 401(k) contributions are tax deductible today, you'll eventually have to pay ordinary income taxes on your contributions and the potential growth when you make withdrawals. Generally, you need to wait until you're age 59½ to begin making withdrawals without penalties. However, if you retire from your current employer at age 55, you can begin taking withdrawals from that employer's 401(k) plan without penalties.

But just because taxes are due when you make a withdrawal doesn't mean the benefits of your pre-tax contributions are completely lost. For example, if you expect to be in a lower tax bracket when you're living in retirement, when you withdraw the funds you could pay lower taxes then you would have during your working years.

Of course, no one can predict the future, much less what taxes will be 10 or 20 years from now. Which is why retirement professionals often say the important thing is to save something now. If you don't dedicate money to retirement now, you may need to invest even more in the future to make up for lost time.

In general, you're expected to wait until you reach age 59½ before making any withdrawals from your 401(k) (or age 55 for your current employer's retirement plan). If you withdraw pre-tax money early, you'll have to pay taxes on the money at your regular marginal tax rate. Plus, you will also be stuck with a 10% penalty from the IRS.

A Roth 401(k) is just a 401(k) that's funded only with after-tax contributions. (You can also make after-tax contributions to a traditional 401(k), but that is less common, and some plans don't allow it.) In the past, Roth contributions could only be made by employees—but they can now be done by an employer as a matching contribution or as profit sharing, as we mentioned before. However, it's up to each employer to decide if this provision will be a part of their retirement plan. If a 401(k) plan allows employee Roth contributions, it's up to you to decide whether after-tax Roth or pre-tax traditional contributions are made. You can also make a combination of both types, if both are available to you.

When you make Roth contributions to your 401(k), your money goes in after taxes. As a result, you won't see any tax savings in the year you make the contribution. But because you've already paid taxes on the money you contribute, when you make qualified withdrawals from a Roth account, it won't be taxed. And you won't be taxed on potential investment gains in your Roth account. Any qualified withdrawal from the Roth account will generally be U.S. federal tax-free, provided you are 59½ or older (or the age 55 rule applies) and it's been 5 tax years since your first contribution to the account.

If you think you'll have a higher income in retirement than you do today, it might make sense to contribute to a Roth account—rather than making tax-deductible contributions now. This will allow you to pay taxes on your Roth contribution today, potentially at a lower tax rate than if you delayed the taxes until later when you are in a higher tax bracket.

An additional advantage for higher earners is that there's no income limit connected to 401(k) Roth contributions, so you won't see your ability to contribute phased out like it is for a Roth IRA.

The traditional pre-tax 401(k) can potentially be a great tool to help you plan for your future in a tax-efficient manner. If your employer allows Roth employee contributions or after-tax contributions, this offers additional tax-planning opportunities. Due to the numerous alternatives available and the complexity of tax codes, we recommend consulting with a tax and/or financial professional to help you determine the most tax efficient way to participate and to withdraw assets in retirement. To learn more about maximizing your contributions to tax advantaged account check out this article, "Saving Outside Your 401(k)."

Schwab does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances.

Maximum contribution limits cannot be exceeded. Contribution limits provided are based on federal law as stated in the Internal Revenue Code. Applicable state law may be different.