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 2019, the maximum contribution limit was $19,000, and those age 50 or older were able to contribute a "catch-up" amount of an additional $6,000. (For 2020, the maximum contribution limit is $19,500 and the catch-up amount is $6,500.) For example, if a 40-year-old employee who makes a $100,000 a year salary contributes the full amount of $19,500, the reported income from the employer shows $80,500. The original contribution of $19,500 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 $6,000, with a $1,000 catch-up. (This amount is the maximum for both 2019 and 2020.) 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 contribution rate of $19,000 per year (total, including both employer and employee contribution), plus an additional $6,000 catch-up contribution for employees age 50 or older (with 2020 maximums of $19,500 and $6,500, respectively). Roth IRAs have a max contribution of $6,000, plus an additional $1,000 for employees age 50 or older, in 2019. (IRA contributions are unchanged for 2020).
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. 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).
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 options once 401(k) contributions have been maxed out.