401(k) tax advantages for employees

Warren Buffett said it best: “Someone is sitting in the shade today because someone planted a tree a long time ago.” To reach the recommended $1 million nest egg goal for most retirees ($2 million if you’re a millennial!), contributing early to a retirement account is key. 

The U.S. government provides tax credits to employers and employees to encourage them to set up and save with 401(k) plans. And people are taking advantage of these plans. According to the Investment Company Institute, Americans held $11.3 trillion in employer-based defined contribution retirement plans in 2024—over 70% of which was in 401(k) plans. 

Saving for retirement is a good idea. But given the additional tax benefits and breaks of a 401(k) in particular, it’s an absolute must to be informed about how much they can help you financially—both now and in the future.

The immediate benefit: Lower your tax bill

Every time you contribute to your 401(k) using pre-tax dollars from your paycheck, your taxable income for the current tax year decreases. This is possible because you’re deferring taxation until retirement—a time in which you’re more likely to be in a lower tax bracket (compared to your working years). 

Example: Let’s assume you’re on track to make $70,000 in total taxable income in 2024 and that income will remain the same for the next five years. As a single filer with no deductions, you’ll owe $10,459 to the IRS. However, by contributing to a 401(k), here’s how much less you could have owed in income tax:

In 2025, individuals under 50 are able to contribute up to $23,500 to a 401(k). Thanks to catch-up contributions, individuals over 50 years old can contribute up to $31,000 (and those aged 60-63 can save up to $34,750). Just by socking away $3,000 into a 401(k), you’ll see nearly $700 in tax savings. Assuming the same scenario for five years, you would pay a total of about $3,500 less in taxes for that period. The more you contribute to your 401(k), the less you pay on income taxes—which can be especially beneficial for those in higher income tax brackets.

Start early or adjust accordingly

Let’s imagine your retirement goal is $1 million and your 401(k) includes a mutual fund with an average annual return of 7% compounded annually¹. Your target retirement age is 65.

*Note: The IRS caps 401(k) contributions at $27,000 for individuals aged 50 or older—so start saving early!  

How compound interest can benefit savers

If you’re relatively young, the later you start saving, the higher the total amount of money you’ll have to set aside. By contributing small amounts now, you could have more saved eventually than if you don’t contribute anything at all. This is thanks to compound interest, which could be very beneficial to you if time is on your side. 

However, a 401(k) is still beneficial for those starting later in life to save for retirement. First, a 401(k) has a higher contribution limit ($23,500 and $7,500 in catch-up contributions in 2025) than an IRA ($7,000 and $1,000 in catchup contributions in 2025). Second, when using a 401(k) instead of a traditional IRA, you may delay required minimum distributions (RMD) past age 70 ½ by continuing to work. Under this scenario, you continue to make contributions, your 401(k) continues to grow tax-deferred, and your first RMD would be on April 1 of the year after you retire. (Note: Not all 401(k) plans allow this tactic, so talk with your plan administrator in advance).

The long-term advantage: Pay less in taxes during retirement

The years go by and now you’re in your mid-60s. Let’s assume you’ve reached your goal of a $1 million nest egg. However, you don’t want to change your lifestyle at all and decide to live on the above example of a $70,000 annual salary. Assuming you’re single and withdraw the entire amount from your 401(k), here’s the breakdown of your applicable income taxes:

Your bracket depends on your taxable income and filing status. (Refer to the IRS tax schedules for 2024). Below are individual (single) taxpayers tax rates for 2025:

As this shows, there are seven tax brackets for the 2025 tax year. Falling in a tax bracket doesn't mean you owe that rate on your entire income. The U.S. follows a progressive tax system in which the government divides taxable income into different brackets. Each bracket is taxed at a corresponding rate. People with higher taxable incomes are subject to higher federal income tax rates, while those with lower taxable incomes are subject to lower federal income tax rates. No matter where you fall, however, you won’t pay one single tax rate on your entire income. Instead, your tax rate is staggered across multiple brackets.

How social security factors into your retirement

It’s important to note that these scenarios assume you have no additional sources of income—which is not often the case. For example, the average monthly social security benefits payable in January 2024 (after adjusting for a cost of living adjustment) was $1,657 or $19,884 per year. 

By diversifying your revenue streams pre-retirement, you may see more flexibility than if you had only your 401(k) to withdraw from once retired. Depending on your sources of income during retirement, you could make adjustments to stay in a lower tax bracket. For example, to stay in the 15% tax bracket, you could fund a total of $10,350 ($48,000 minus the $37,650 upper limit of the 15% tax bracket) from a savings account. Or, you could adjust your lifestyle to reduce your necessary expenses. 

Delaying Social Security payments can be advantageous. Social Security benefits increase a certain percentage each month you delay your benefits beyond your full retirement age. While you can get a boost to your benefit right away (i.e., one month after you reach your full retirement age), each month you postpone filing, Social Security increases your benefits by two-thirds of one percent. Social Security credits max out at age 70, which means your monthly benefit will not be eligible for any additional increase after this age.

How much money do you need in retirement?

This is the million-dollar question in retirement (often, quite literally). While final numbers can fluctuate, many industry experts agree it’s a good practice to consider replacing between 70% to 80% of your pre-retirement income. Why this number? First off, your taxes may be less than what you’re currently paying in retirement. If you aren’t planning to work, you won’t be responsible for payroll taxes. It’s also important to consider a decrease in living expenses. For example, you may have paid off big-ticket items like your mortgage, your kids’ college tuition bills, or other debts. This can significantly reduce your monthly bills. 

Remember: You have to follow the rules to get the tax breaks!

The IRS is willing to give you a tax break on your 401(k), but you have to follow three important rules:

• Don’t take early distributions (before age 59 ½): Not only will you pay at a lower tax bracket than in retirement but also you’ll pay an extra 10% penalty. Certain states may charge additional income taxes and penalties. This is to encourage long-term saving.

• Keep contributions at or below the maximum limit: The IRS allows you to withdraw excess deferrals no later than April 15th of the following year. Any excess deferrals not withdrawn by the deadline are subject to double taxation; that is, they’re taxed both in the year contributed to and in the year distributed from the plan. Also, excess deferrals may be subject to early distributions penalties when done before age 59 ½. Contact your plan administrator to find out how much you can contribute to your plan (often, a percentage based on the participant’s compensation). 

• Pay back all 401(k) loans in full: As a rule of thumb, it’s also wise to resist taking early distributions or loans from your 401(k) to avoid paying penalties. Any unpaid loan balances from 401(k) become taxable income and can be subject to early distribution penalties. Generally, 401(k) plans that allow loans permit plan holders to pay loans within five years or 60 days after the termination of employment.

Tax advantages for employers

As we’ve mentioned above, the U.S. government wants to encourage people to save for retirement and provides strong financial incentives for doing so through a 401(k). Because they know that 401(k)s are employer-administered, they also provide corporate tax credits and benefits as well! You can read about this in more detail, but here are the main points:

• Corporate tax credit: $1,500 over three years for new 401(k) plans.

• Tax-deductible employer match: Because 401(k) matches are deductible from an employer's income, this is a more cost-effective way to reward employees than a bonus or a raise while lowering your tax basis. It’s a double-sided tax benefit, since neither the employer nor the employee have to pay taxes on the match—whereas with a raise or a bonus, both are losing out on the full raise or bonus amount due to taxes.

Ultimately, a 401(k) provides substantial tax advantages for employees (and employers), such as a higher contribution limit than some retirement accounts and tax deferral until retirement. But you need to play by the rules set by the IRS to ensure you’re getting the most value from your account. If you’re an employer looking to empower your employees, starting a 401(k) plan can be a great way to help them benefit from these numerous tax advantages.