How Retirement Contributions Affect Taxes

Income taxes and retirement accounts are two topics that are complex and at times confusing. There is also quite a bit of information to research and sift through. This article hopes to help ease some of that confusion by giving a strong outline of the individual details, all in one place. So here is some vital information on each type of retirement account and how putting money into them, or taking money out of them, can affect your personal federal income taxes.

Traditional Individual Retirement Account

As the name states, a traditional individual retirement account, or IRA for short, is an account that an individual personally opens and funds. The account can be opened with a bank, credit union, or financial advisor — popular custodians include institutions like Fidelity Investments, Charles Schwab, Vanguard, and TD Ameritrade, to name a few. The IRS allows a deduction from income for money contributed to an IRA during any given tax year; however, it is limited. In general, for tax year 2025, you can contribute and deduct up to $7,000 if you are under 50 and $8,000 if you are 50 or older, according to IRS retirement topics on IRA contribution limits. This limit applies to the total you contribute to any and all IRA’s, not each one separately, including Roth ones. It is also important to understand the IRS will penalize you if you contribute more than that. The upside is that as long as your income is not above the IRS threshold, you can deduct the full amount contributed to your traditional IRA from your income before income tax is calculated.

So how does it affect your federal income tax if you take money out of your traditional IRA? If you are over 59 ½, all withdrawals are completely taxable, and this is because a deduction from tax was already received at the time the money was contributed. There are exceptions if you did not qualify for the deduction the year of contribution, so keep that in mind. If you are younger than 59 ½, you will also be charged a 10% penalty in addition to the income tax you owe, as outlined in IRS Tax Topic 557. There are exceptions to the penalty, as follows:

-Medical expenses exceeding 7.5% of your AGI
-Qualified higher education expenses
-First time home buyer, limited to $10,000
-Birth or adoption expenses, limited to $5,000
-Death, disability, or terminal illness
-Health insurance while unemployed
-Taking periodic equal payments from the plan for at least 5 years
There are additional exceptions that are rare, and available on the IRS website’s page on early distributions.

Traditional IRA Income Limits and Deductibility

The ability to deduct your traditional IRA contribution depends not just on how much you earn, but also on whether you or your spouse is covered by a workplace retirement plan. The IRS sets modified adjusted gross income (MAGI) phase-out ranges that determine how much, if any, of your contribution is deductible. For 2025, if you are covered by a workplace plan and file as single or head of household, the phase-out range is $77,000 to $87,000. For married filing jointly where the contributing spouse is covered by a workplace plan, the range is $123,000 to $143,000, according to IRS Publication 590-A.

If your income exceeds the upper end of the phase-out range, you can still contribute to a traditional IRA — but you will not receive a tax deduction. This is sometimes called a “non-deductible IRA.” Financial planning firms like Fidelity and Vanguard often recommend keeping careful records using IRS Form 8606 when making non-deductible IRA contributions, so you are not taxed again on that money when you eventually withdraw it.

Roth IRA

Roth IRA’s are very similar to traditional IRA’s in how you create them and fund them. You are limited as to how much you can contribute each year as stated above. The major difference is that the contributions are not deductible from your income for tax purposes. Roth IRAs were established under the Taxpayer Relief Act of 1997 and are named after their chief legislative sponsor, the late Senator William Roth of Delaware. Today, platforms like SoFi, Betterment, and Robinhood have made Roth IRA accounts accessible to a broader range of investors, including younger workers just entering the workforce.

Withdrawing money from a Roth IRA generally speaking is tax-free. Since there was no deduction for the contributions, income tax was essentially already paid on the funds. It is important to note that the money you put into a Roth IRA is always tax-free when withdrawn. Any income tax or penalties due would be calculated on the earnings, meaning any interest and dividend the money earned during investment. This can happen when the money is withdrawn early. Early here can refer to not being 59 ½ or older, with the same guidelines as traditional IRA’s. With the Roth IRA, early can also mean the account was not open for at least 5 years before withdrawing. This is known as the five-year rule, and it is a critical distinction that even experienced investors sometimes miss, as explained in detail by Investopedia’s guide to the Roth IRA five-year rule.

Roth IRA Income Limits for Contributions

Unlike traditional IRAs, you cannot contribute to a Roth IRA at all if your income exceeds certain limits. For 2025, the ability to contribute to a Roth IRA phases out for single filers with a MAGI between $146,000 and $161,000, and for married filing jointly between $230,000 and $240,000, per IRS guidance on Roth IRA contribution limits. High earners who exceed these limits may consider a strategy known as the “backdoor Roth IRA”, which involves making a non-deductible contribution to a traditional IRA and then converting it to a Roth IRA. This strategy is legal and widely discussed by financial advisors at firms such as Charles Schwab and Edward Jones, though it comes with its own set of tax complexities.

401K

A 401K retirement plan is one established by an employer as an employee benefit. Both the employer and employee will contribute to the plan. These contributions are made by the employee pre-tax, meaning the amount is not included in federal taxable income. That means that like a traditional IRA, money a person puts into his or her own 401K receives a tax benefit. For 2025, employees can contribute up to $23,500 to their 401(k) plan, with an additional $7,500 catch-up contribution permitted for those aged 50 and older, according to IRS Notice 2024-80. Major employers that administer 401(k) plans often work with large recordkeepers like Fidelity Investments, Vanguard, Empower Retirement, and Principal Financial Group.

Also similar to a traditional IRA, since there was a tax deduction at the time of contribution, when the money is withdrawn from a 401K, it is then taxable income. The same rules also apply for early withdrawals and the 10% penalty as they do for traditional IRA’s. The one difference is that to avoid the penalty, withdrawals from 401K’s do not include the exceptions for education expenses, first time home purchases, or health insurance premiums while unemployed. It is also worth noting that the SECURE 2.0 Act of 2022, signed into law by Congress, introduced several updates to 401(k) rules, including new provisions for emergency withdrawals and expanded catch-up contribution limits for workers aged 60–63, as detailed by the U.S. Department of Labor.

Employer Matching and Its Tax Implications

One of the most valuable features of a 401(k) is the employer match — essentially free money added to your retirement savings. Employer contributions do not count toward your personal $23,500 employee contribution limit, but the combined total of employer and employee contributions cannot exceed $70,000 for 2025 (or $77,500 with catch-up contributions), according to IRS 401(k) contribution limit guidance. Employer matching contributions are also tax-deferred, meaning they are not taxed until you withdraw them in retirement. The Employee Benefits Security Administration (EBSA), a division of the U.S. Department of Labor, oversees the rules that govern employer-sponsored plans and protects employee rights under ERISA (Employee Retirement Income Security Act).

Pension Plan

Pension plans are completely funded by employers as a benefit for the employees. While this is a great job benefit, contributions offer the employee no income tax benefit. Pension plans — also known as defined benefit plans — are increasingly rare in the private sector. According to data from the U.S. Bureau of Labor Statistics, only about 15% of private-sector workers had access to a defined benefit pension plan as of recent surveys, compared to much higher rates in state and local government employment. Notable organizations that still maintain robust pension programs include the U.S. federal government through the Federal Employees Retirement System (FERS) and many state governments. The Pension Benefit Guaranty Corporation (PBGC), a federal agency, provides insurance protection for private-sector pension benefits in the event an employer cannot meet its obligations.

Withdrawals from a pension plan are completely taxable no matter when they are taken. The money is also subject to the 10% penalty if withdrawn before the age of 59 ½. To avoid the 10% penalty the rules are the same for pension plans as they are for 401K’s.

It is important to note that for some occupations, such as police officers and public school teachers, if you serve the job a certain number of years you may collect your retirement funds without the 10% penalty no matter your age when you retire from the job.

Retirement Account Contribution and Tax Comparison Table

Required Minimum Distributions (RMDs)

One critical aspect of retirement account taxation that affects all traditional IRA, 401(k), and pension account holders is the Required Minimum Distribution (RMD). The IRS requires that you begin withdrawing a minimum amount from tax-deferred retirement accounts once you reach a certain age. Under the SECURE 2.0 Act of 2022, the RMD starting age was raised to 73 for individuals who turn 72 after December 31, 2022. The RMD age is scheduled to increase further to 75 for those who turn 74 after December 31, 2032, per IRS guidance on RMDs.

Failing to take your required minimum distribution results in a steep excise tax. Prior to the SECURE 2.0 Act, the penalty was 50% of the amount not withdrawn. The SECURE 2.0 Act reduced this penalty to 25%, and further to 10% if the error is corrected in a timely manner. Roth IRAs, notably, are not subject to RMDs during the original owner’s lifetime — a significant tax planning advantage that financial advisors at firms like Edward Jones and Raymond James often leverage in long-term retirement strategies.

Tax Withholding on Retirement Distributions

When you take a distribution from a traditional IRA, 401(k), or pension plan, the payer is generally required to withhold federal income tax. For most retirement plan distributions, the default withholding rate is 20% for eligible rollover distributions. For periodic payments such as monthly pension checks, withholding is calculated similarly to regular wage withholding using IRS Form W-4P. You can choose to have more or less withheld, but it is important to ensure enough tax is paid throughout the year to avoid underpayment penalties. The IRS provides a withholding estimator tool at IRS.gov to help retirees calculate their expected tax liability, as noted in IRS guidance on tax withholding for individuals.

Rollovers and Their Tax Implications

When you change jobs or retire, you may choose to roll over your 401(k) balance into another retirement account. A direct rollover — where funds move directly from one plan to another — is not a taxable event and avoids mandatory withholding. An indirect rollover, where the funds are distributed to you and you then deposit them into another eligible account, must be completed within 60 days to avoid taxes and penalties. However, with an indirect rollover, the plan administrator will withhold 20% for federal taxes, which you must make up out of pocket when redepositing the full amount to avoid paying taxes on the withheld portion, as detailed by the IRS rollover rules guidance. Financial institutions like Fidelity, Schwab, and Vanguard can facilitate direct rollovers with minimal administrative friction.

This information is by no means extensive enough to include all the details you can run into in unusual situations, but gives a good basis from which to start. This article also only discusses the affects on federal income taxes, since the individual states have their own rules and taxation. There are also other, less common types of retirement accounts, such as Roth 401K’s and Simple IRA’s, so keep those in mind as well. It is definitely important to know the tax consequences of contributing to and withdrawing from any retirement account in your financial planning. It is also worth noting that having a good accountant — or working with a Certified Financial Planner (CFP®) registered with the Certified Financial Planner Board of Standards — can help with the information, and decisions you make regarding your retirement funds. For tax-specific questions, a Certified Public Accountant (CPA) affiliated with the American Institute of CPAs (AICPA) can provide personalized guidance. The Consumer Financial Protection Bureau (CFPB) also offers free retirement planning resources at consumerfinance.gov to help individuals navigate their options.

Frequently Asked Questions

Do retirement contributions reduce my taxable income?

Yes, contributions to traditional IRAs and 401(k) plans directly reduce your federal taxable income in the year they are made. For example, contributing $7,000 to a traditional IRA could lower your taxable income by up to $7,000, depending on your eligibility. Roth IRA contributions do not reduce taxable income, but qualified withdrawals in retirement are completely tax-free.

How much can I contribute to a traditional IRA in 2025?

For tax year 2025, the IRA contribution limit is $7,000 for individuals under age 50 and $8,000 for those 50 and older. This limit applies to the combined total of all traditional and Roth IRAs you own. Contributing above this limit results in a 6% excise tax on the excess contribution each year it remains in the account, per IRS rules.

What is the 401(k) contribution limit for 2025?

The employee elective deferral limit for 401(k) plans in 2025 is $23,500. Workers aged 50 and older can contribute an additional $7,500 as a catch-up contribution, bringing their total to $31,000. A new provision under SECURE 2.0 allows workers aged 60–63 an even higher catch-up limit of $11,250 starting in 2025.

What is the 10% early withdrawal penalty for retirement accounts?

The IRS imposes a 10% additional tax on distributions taken from traditional IRAs, 401(k)s, and pension plans before you reach age 59½. This penalty is on top of the ordinary income tax owed on the withdrawal. There are specific exceptions — such as for disability, certain medical expenses, or substantially equal periodic payments — that allow early access without the penalty.

Is a Roth IRA withdrawal ever taxable?

Withdrawals of your original contributions from a Roth IRA are always tax-free and penalty-free at any age. However, the earnings on those contributions may be taxable and subject to the 10% penalty if the account is less than 5 years old or if you are under age 59½. Once both conditions are met (account is 5+ years old and you are 59½ or older), all withdrawals — contributions and earnings alike — are completely tax-free.

Do I have to pay taxes on pension income?

Yes. Pension plan payments are generally fully taxable as ordinary income at the federal level when received, because contributions to traditional pension plans were made on a pre-tax basis. The amount you receive each year from your pension should be reported on IRS Form 1099-R. State tax treatment of pension income varies widely — some states fully exempt pension income, while others tax it in full.

What are Required Minimum Distributions (RMDs) and when do they start?

RMDs are minimum amounts the IRS requires you to withdraw annually from tax-deferred retirement accounts like traditional IRAs and 401(k)s. Under the SECURE 2.0 Act of 2022, RMDs must begin at age 73 (or 75 if you turn 74 after December 31, 2032). Failing to take the full RMD results in a 25% excise tax on the shortfall (reduced to 10% if corrected promptly). Roth IRAs are exempt from RMDs during the owner’s lifetime.

Can I contribute to both a 401(k) and an IRA in the same year?

Yes, you can contribute to both a 401(k) and an IRA in the same tax year. However, if you (or your spouse) are covered by a workplace retirement plan, your ability to deduct traditional IRA contributions may be limited based on your income. There is no income limit restricting your ability to make non-deductible traditional IRA or Roth IRA contributions (subject to Roth income limits) alongside a 401(k).

What is the difference between a traditional IRA and a Roth IRA for tax purposes?

The primary tax difference is when you receive the tax benefit. With a traditional IRA, contributions may be tax-deductible now, but withdrawals in retirement are taxed as ordinary income. With a Roth IRA, contributions are made with after-tax dollars (no deduction now), but qualified withdrawals in retirement are completely tax-free. Your expected tax rate in retirement versus today is the key factor in deciding which is more advantageous for your situation.

What is a SIMPLE IRA and how is it taxed?

A SIMPLE IRA (Savings Incentive Match Plan for Employees) is a retirement plan designed for small businesses with 100 or fewer employees. Both employees and employers can contribute. For 2025, employees can contribute up to $16,500 ($20,000 for those 50+). Contributions are pre-tax, reducing your taxable income, and withdrawals in retirement are taxed as ordinary income — similar to a traditional IRA. One key distinction: early withdrawals within the first two years of participation are subject to a steeper 25% penalty rather than the standard 10%.