Traditional 401(k) contributions effectively reduce both adjusted gross income (AGI) and modified adjusted gross income (MAGI). Participants can defer a portion of their salaries and claim tax deductions for that year.
However, a Roth 401(k) contribution offers no immediate income reduction, as it consists of after-tax dollars.
Key Takeaways
- Traditional 401(k) contributions effectively reduce both adjusted gross income (AGI) and modified adjusted gross income (MAGI).
- The potential of tax deferral and reduction of current taxable income means that traditional 401(k) contributions offer ways to soften tax liabilities.
- In 2023, the maximum contribution limit is $22,500, increasing to $23,000 in 2024. Those age 50 or older are able to contribute a "catch-up" amount.
- Roth 401(k) contributions don't reduce either AGI or MAGI, as they are made with after-tax dollars.
401(k) Contributions
To contribute to a 401(k), an employee must be eligible and the employer must offer such a plan. Then, an employee may begin deferring a percentage of their salary toward that plan throughout the year. Any amount contributed to the plan up to the IRS limit is considered a reduction of that employee's taxable wage.
In 2023, the maximum contribution limit is $22,500 (increasing to $23,000 in 2024). Those age 50 or older can contribute a 2023 and 2024 "catch-up" amount of an additional $7,500. For example, if a 40-year-old employee who makes a $ 100,000-a-year salary contributes the full amount of $23,000, the reported income from the employer shows $77,000.
The original contribution of $23,000 is deposited into the employee's own personal 401(k) plan to be invested within the plan's options. The employee is taxed only when the funds are distributed from the 401(k) plan or a future rollover IRA.
Traditional 401(k) plans are very attractive for individuals looking to reduce their AGI or MAGI. The potential of tax deferral and reduction of current taxable income offer ways to soften tax liabilities. Many have also found this a better option than a traditional IRA due to the maximum annual contribution for an IRA being limited to only $6,500, with a $1,000 catch-up, in 2023 ($7,000 and $1,000 in 2024, respectively).
If you are interested in contributing to your employer's 401(k) plan, contact your plan sponsor or human resources department. For more tax strategies, consult a tax or financial advisor.
Roth 401(k) and Roth IRA
A Roth 401(k) is an employer-sponsored retirement savings plan, just like a 401(k). However, unlike a 401(k), a Roth 401(k) is funded by after-tax dollars up to the same 2023 contribution rate of $22,500 per year, $23,000 for 2024, plus an additional $7,500 catch-up contribution for employees age 50 or older allowed in both years.
Roth IRAs have a max contribution of $6,500, plus an additional $1,000 for employees age 50 or older, for 2023, and $7,000, plus an additional $1,000, for 2024.
Because a Roth 401(k) and Roth IRA are taxed upfront, they do not lower your AGI/MAGI. The initial contributions are not tax-deductible, but money can be withdrawn without taxation, provided it is a qualified distribution, meaning the account has been held for at least five years and distributions are made after age 59½ or due to other certain specific qualifications.
Roth accounts have income limits in order to participate. In 2023, if a single filer earns more than $153,000 they cannot contribute to a Roth, or $228,000 for married filers. (These limits increase in 2024 to $161,000 and $240,000, respectively).
For Roth 401(k)s, distributions are required after you hit 72 years of age. The RMD age was increased to 72 from 70½ in 2019 under the Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE) Act. After the SECURE Act 2.0 was passed, the age was raised further: 73 in 2023 and will be raised to 75 in 2033.
Roth 401(k)s and Roth IRAs can be good options for people who believe they will be paying a much higher tax rate at retirement than when making contributions. They can also be a good investment and savings option once 401(k) contributions have been maxed out.
What Are the 401(k) Limits?
The contribution limit for a 401(k) plan is $22,500 in 2023, increasing to $23,000 in 2024. If you are age 50 and older, you are allowed a catch-up contribution of $7,500 in both 2023 and 2024.
Do You Make Less Money if You Contribute to a 401(k)?
No, you do not make less money if you contribute to a 401(k). When you contribute to a 401(k), your salary is the same. Your contributions to a 401(k) are deducted from your salary before taxes are deducted from your salary. The money contributed goes into your 401(k) account. From there, the taxes deducted from your take-home pay are lower because your salary is now "lower." Your salary is "lower" because you reduced it by contributing to the 401(k). So while your overall salary stays the same, you end up paying less taxes.
Is 401(k) Money Considered Income?
Yes, 401(k) money is treated like income when you withdraw funds. As you didn't pay taxes on that money, when you withdraw it, it will be taxable at your ordinary income tax level at the time.
The Bottom Line
A 401(k) retirement plan will reduce both your AGI and MAGI, as contributions are taken out of your salary before taxes are deducted. This in effect reduces your salary in relation to taxes. Because your salary is now "lower," you end up paying less taxes. This is the tax benefit of a 401(k) retirement plan.
