Are 401(k) contributions tax deductible?

All pre-tax contributions to qualified retirement plans such as 401(k)s reduce taxable income, which lowers the total taxes owed. For 2018, the annual limit is $18,500, except for people who are 50 or older. They can contribute an additional $6,000 per year, as long as they turn 50 in that calendar year. About 97% of 401(k) plans allows such catch-up contributions. Whether regular or catch-up, the contribution is fully tax-deductible.

Whether regular or catch-up, the 401(k) contribution is taken right off the top of the income for the year, making it more advantageous if you are in a higher tax bracket. For example, suppose a single person earning $55,000 a year has a 401(k) plan and starts setting aside $5,000 a year. At $55,000, he is in the 22% federal tax bracket in 2018. Since the 401(k) contribution is fully deductible, his taxable income for the year drops to $50,000, saving him $1,100 per year.

Meanwhile, a single high-income earner making $201,000 is in the 35% tax bracket (which starts at $200,001). If he starts contributing the maximum amount, $18,500 per year, he drops a full bracket and end up being taxed in the 32% bracket.

There are two reasons why making the contribution, and getting the tax deduction is worthwhile during your working years.

First of all, there's more capital working on your behalf during the years leading up to retirement. A person in the 24% tax bracket with 20 years until he quits can either save a pretax $400 a month in a 401(k) plan or get a post-tax $300 and put it in a regular brokerage account. The extra $100 per month from the first option quickly increases the size of the nest egg, adding the power of compounding over 20 years. It could be tens of thousands extra by the time he bids the work world good-bye.

Second, the distributions (withdrawn funds) from the 401(k) are taxed as regular income. But presumably, you're withdrawing them during retirement. Retirees typically have lower income than they did when they were working. A married couple in the 35% bracket may drop to the 24% bracket once they've retired. They made their deductions to the tune of 35%, but they only pay 24% when collecting their monthly payouts, earning them an extra 11% right off the top.