What is a 401k Tax Deduction?

A 401k tax deduction is a federal income tax deduction that employees can use when they contribute to a 401k retirement fund. For workers, any money that is placed in a 401k retirement account is not taxed at the end of that year. Instead, the money is taxed upon withdrawal when an individual retires and begins to take out the savings in the account, which is known as post retirement income tax.

Unlike a Roth 401k, a traditional 401k tax deduction is permitted for employees who wish to make pre-tax contributions to their retirement accounts. The contribution is then subtracted from the total income in a process similar to other tax deductions. Roth plans do not offer a 401k tax deduction since they involve after-tax contributions. Upon retirement, individuals will not be taxed when they withdraw funds from a Roth 401k.

For the 2011 year, $16,500 US Dollars (USD) is the limit for the amount an employee can contribute to his or her own 401k plan. Individuals over the age of 50 are allowed “catch-up” contributions that total to an extra $5,500 USD per year on top of the original limit. These figures are equal to the maximum 401k tax deduction that an individual employee can claim. Employees who contribute less than the maximum amount can only claim the amount of their contributions for the tax deductions.

Employers will often offer an employer match program, in which they will match the employee’s contributions to a 401k plan. These employer contributions are also made pre-tax, and sometimes the employers will be able to receive a 401k tax deduction on the amount that they contribute to their employees’ retirement accounts. Employers are also limited in the contributions that they make, and the maximum possible contributions cannot exceed $49,000 USD for the 2011 year. The employer contribution must be equal to or less than this total minus the employee contribution, and it cannot exceed the employee’s total gross income.

Pre-tax contributions are permitted to earn interest when the 401k account is placed in various investments, and the interest earned is also tax-exempt until withdrawal upon retirement. This also makes 401k plans beneficial, as it exempts individuals from paying taxes on their retirement accounts’ interest. The interest income earned is also reinvested in the account, so if an individual begins to save for retirement early, he or she will ultimately benefit from the potential gains of the interest reinvestment.