Traditional 401(k) contributions from pay

How it works

The worker picks a percent or dollar amount on the plan's website, and payroll takes it out of each check before federal income tax is calculated, though Social Security and Medicare tax still apply to it. The yearly cap on what a worker can put in is this year's official 401k elective deferral limit (not yet verified here; see the official source below), and that cap covers all of a person's 401(k) and 403(b) deferrals across every job that year. The money is invested in the plan's fund menu and grows without yearly tax on dividends or gains. Withdrawals are taxed as ordinary income, and a withdrawal before age 59 and a half usually carries a 10 percent (2025, verified on the official page) percent addition unless an exception the IRS lists applies. The plan document and the summary plan description state the details.

What it gives

Each dollar deferred lowers taxable income for the year it goes in, so the tax bill shrinks right away.

Growth inside the plan is not taxed year by year, which lets the balance compound without drag.

Payroll deduction happens before the money reaches a checking account, which many people find easier than saving by hand.

What it costs, or where the catch is

Every dollar that comes out later is taxed as ordinary income, including all the growth.

Money taken out before 59 and a half usually carries the penalty on top of the tax, unless an exception applies.

The fund menu is chosen by the employer, and some menus carry fees higher than a person would pay elsewhere.

A worked example

Nadia earns $60,000 and sets her deferral at 10 percent, which is $6,000 for the year. Her taxable wages for federal income tax fall to $54,000, and at a 22 percent marginal rate the tax saved this year is $6,000 times 0.22, or $1,320. Her take home pay drops by $6,000 minus $1,320, which is $4,680, while $6,000 lands in the plan. The tax is owed later, when she withdraws.

Where it goes wrong

A common miss is treating the deferral as money that is gone, rather than money that is parked, and so never checking that it is invested in anything beyond the cash option.

Who confirms it for you

For your own numbers, the plan administrator or HR. This page explains how the rule works for people in general; it does not know your situation and does not tell you what to do.

The official source

IRS: 401(k) and profit sharing plan contribution limits. Every figure that changes by year comes from the site's rules table, which the watcher checks against the official page on a schedule; where a figure is not yet verified, this page says so instead of printing a number.