Participating in your employer's 401(k) plan allows you set aside money for retirement and get some nice tax breaks. Contributions might reduce taxable income. That depends on the type of contributions made and whether you or your employer makes the contribution.
Your contributions to a 401(k) plan are sometimes called salary reductions. This does not mean you got a pay cut. Rather, the money you contribute is credited directly to your 401(k) account, so your taxable income is calculated without taking your contribution into consideration. The result is that a 401(k) contribution reduces taxable income. Your contributions and investment earnings are not taxed until you withdraw them from the 401(k).
As of 2012, Internal Revenue Service rules allow you to add up to $17,000 each year to your 401(k) plan as long as you earned at least that much money. This is an increase from the previous limit of $16,500. Your taxable income is reduced by the amount you contribute up to this limit. The limit is adjusted annually, so check with your plan administrator for current figures. When you reach age 50, the IRS allows you to add more money, referred to as a catch-up contribution. Catch-up contributions are also tax deductible and reduce your taxable income. As of 2012, the catch-up limit was $5,500, bringing the total contribution limit to $22,500 when you reach age 50.
Employers have the option of adding matching contributions to 401(k) plans. Typically, employer contributions are calculated as a percentage of your salary or your contributions. Like the money you put into your 401(k), employer contributions are tax free. However, because they are not part of your salary, employer matching contributions do not affect your taxable income.
Designated Roth Accounts
Some 401(k) plans offer the option of making contributions to a designated Roth account. Designated Roth contributions are credited to a separate account within your 401(k) plan. You don’t get to deduct designated Roth contributions, so they do not reduce your taxable income. Instead, the money in your designated Roth account is tax-free when it is withdrawn. Only you can make designated Roth contributions. Your employer’s matching contributions must be tax-deferred and may not be part of the designated Roth portion of your 401(k).