401k and Taxes Explained

Traditional 401(k): Reduce Taxes Now, Pay Later

A traditional 401(k) contribution is pre-tax — it reduces your taxable income in the year you contribute, providing an immediate tax benefit.

How it works for a $75,000 earner in the 22% bracket:

- Without 401(k): taxable income = $60,000, federal tax = $8,115

- With $10,000 traditional 401(k): taxable income = $50,000, federal tax = $5,915

- Tax savings: $2,200/year ($183/month)

- Net cost of a $10,000 contribution: $7,800 (you "save" $2,200 in taxes)

When funds are withdrawn in retirement:

Withdrawals are taxed as ordinary income in the year taken. If you're in the 12% bracket in retirement, you pay only 12% on withdrawals — having deferred 22% today. This is the traditional 401(k) tax arbitrage.

Required Minimum Distributions (RMDs):

Starting at age 73, the IRS requires minimum annual withdrawals from traditional 401(k)s. Failure to take RMDs results in a 25% excise tax on the amount not withdrawn. This is important planning consideration for workers who don't need retirement income early — Roth accounts have no RMD requirement during the owner's lifetime.

Roth 401(k): Pay Taxes Now, Withdraw Tax-Free

Roth 401(k) contributions are made with after-tax dollars — no immediate tax deduction. But qualified withdrawals in retirement (after age 59½, account open 5+ years) are entirely tax-free, including all investment growth.

How it works for the same $75,000 earner:

- Roth 401(k) contribution: $10,000 (after-tax)

- No immediate tax savings — full $10,000 comes from after-tax income

- Taxable income remains $60,000

- In retirement: $10,000 + decades of growth withdrawn completely tax-free

The Power of Tax-Free Growth:

If you invest $10,000 at age 30 and it grows to $97,000 by age 65 (7% annual return over 35 years), that $87,000 gain is:

- Traditional 401(k): taxed in retirement (potentially $10,440–$23,490 in taxes)

- Roth 401(k): completely tax-free ($0 in retirement taxes)

Roth 401(k) RMD Rule Change:

Beginning in 2024 (under SECURE 2.0), Roth 401(k) accounts are no longer subject to RMDs during the owner's lifetime — matching the longstanding Roth IRA rule. This makes Roth 401(k) an even more attractive choice for younger workers.

2026 Contribution Limits: 401(k), IRA, HSA

Traditional vs. Roth 401(k): How to Decide

The classic rule of thumb: choose traditional if you expect to be in a lower tax bracket in retirement; choose Roth if you expect higher future taxes.

Arguments for Traditional 401(k):

- You're currently in the 22%+ bracket and expect to retire in the 12% bracket

- You need to reduce current taxable income (to qualify for other credits, deductions, or avoid bracket creep)

- You're older and have less time for tax-free growth to compound

Arguments for Roth 401(k):

- You're early in your career in a low bracket (10%–12%) that will likely increase

- Tax rates in general are historically low and may rise

- You want tax diversification in retirement

- You don't want RMD complexity in retirement planning

- You expect significant Social Security income (which can push retirement bracket up)

The Data Point Many Miss:

If your combined federal + state marginal rate exceeds 25–27%, traditional almost always wins mathematically. If it's below 20%, Roth is typically better. In the 20–27% range, the decision depends heavily on your specific retirement income projections.

The Practical Answer for Most Workers: Contribute at least enough to your traditional 401(k) to capture the full employer match (that's a guaranteed 50–100% instant return). Then consider a Roth for additional contributions if you're in the 12% bracket or expect rates to rise.

How 401(k) Contributions Show on Your Paycheck

Your 401(k) contributions appear on your pay stub and W-2 in specific ways:

Pay Stub:

- "401(k)" or "RETIREMENT" deduction line showing per-paycheck amount

- Reduces gross to reach "taxable wages" before federal/state tax calculation

- Note: FICA (Social Security + Medicare) is calculated on wages BEFORE 401(k) deductions — so contributions don't reduce your FICA taxes

W-2 at Year End:

- Box 12 Code D: Traditional 401(k) contributions (tax-deferred)

- Box 12 Code AA: Roth 401(k) contributions (after-tax)

- Box 1 (Wages): Will show wages MINUS traditional 401(k) contributions

- Box 3 (Social Security wages): Will show FULL wages including 401(k) contribution

This explains why your W-2 Box 1 and Box 3 often differ — the FICA wage base ignores your traditional 401(k) contribution, while your income for federal tax purposes is reduced by it.

Frequently Asked Questions