Traditional 401(k) contributions effectively reduce both adjusted gross income (AGI) and modified adjusted gross income (MAGI). Participants are able to defer a portion of their salaries and claim tax deductions for that year. A Roth 401(k), similarly to a Roth IRA, is funded through after-tax dollars and offers no immediate tax deduction.
Traditional 401(k) plan contributions are not considered to be deductions on a 1040 tax return, like a contribution to a traditional IRA. 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 his 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 2018, the maximum contribution limit is $18,500, and those age 50 or older are able to contribute a "catch-up" amount of an additional $6,000. For example, if a 40-year-old employee who makes a $100,000 a year salary contributes the full amount of $18,500, the reported income from the employer shows $81,500. The original contribution of $18,500 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 from a future rollover IRA.
Traditional 401(k) plans are very attractive for individuals looking to reduce their AGI/MAGI. The potential of tax deferral and reduction of current taxable income offer ways to reduce tax liabilities. Many have also found this a better option than a traditional IRA due to the maximum annual contribution being limited to only $5,500, with a $1,000 catch-up. 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.