A 401(k) is an employer-sponsored retirement plan that allows pretax contributions, which provide tax savings. To enable the pretax feature, the plan must be a traditional 401(k), or a similar type such as a SIMPLE 401(k) or safe harbor 401(k). Pretax contributions are exempt from certain taxes.
Federal Income Tax
Pretax 401(k) deductions are not subject to federal income tax. The employer subtracts the contribution from wages before withholding federal income tax, lowering the employee's taxable wages. When the employee withdraws from the plan, she will owe federal income tax on her contributions.
Federal income tax is due on employer matching amounts and investment growth upon withdrawal.
State Income Tax
Most states do not require that employers withhold state income tax from pretax 401(k) contributions. Still, state laws vary. Employers may check with the state revenue agency to determine if state income tax must be withheld from pretax 401(k) contributions.
For example, employers in Pennsylvania must factor in 401(k) deductions when withholding state income tax. The employee, however, will not owe Pennsylvania income tax on his contributions upon withdrawal. Employer contributions and investment earnings are also not taxable in Pennsylvania.
Local Income Tax
Cities and counties that impose local income tax usually do not require withholding from 401(k) contributions. Local laws vary, so an exception may apply. For example, employers in Pennsylvania must take local income tax out of 401(k) contributions. Employers may consult the state revenue agency or local tax assessor for withholding rules concerning 401(k)s.
401(k) contributions are not exempt from Social Security or Medicare taxes. In addition, employers must count 401(k) contributions in wages when figuring the taxable wage base for federal unemployment tax.
Pretax 401(k) deductions are not included in federal wages, or box 1, of employees' W-2s. For informational purposes, the employer may put the pretax amount in box 12, under code "D." If the deductions are exempt from state and local taxes, they are not counted in state or local wages, which are boxes 16 and 18, respectively. Pretax 401(k) contributions must be included in Social Security wages (box 3) and Medicare wages (box 5).