A 401(k) plan is an employer-sponsored retirement plan that allows you to save for your retirement and get a tax deduction at the same time. You have money withheld from your paycheck, and that money is deposited into your 401(k) account. You receive a deduction on your income tax return because this contribution is not included in your wages in box 1 of your Form W-2. You pay income tax on the amount shown in box 1 on your Form W-2. Since the contribution to the 401(k) is not included in the box 1 amount, you do not pay tax on it. Your contribution is tax deferred.
The amount you contribute to your 401(k) plan is shown in box 12 of your Form W-2 with a code “D”. You only need to enter your W-2 showing box 12 into TurboTax. You do not need to enter your 401(k) contribution anywhere else in TurboTax.
There is a limit on the amount you can contribute. For 2006 the maximum amount you can contribute is $15,000 ($20,000 if age 50 or older). For 2007 the maximum amount is $15,500 ($20,500 if age 50 or older).
Your 401(k) can grow on a tax deferred basis. That is, you do not pay any income tax on the earnings that are in the 401(k) plan.
Your employer may also make matching contributions for you. These matching contributions are also tax deferred.
However, you do not avoid taxes altogether. Notice that the 401(k) plan is a tax deferred, not a tax free arrangement.
When you retire and receive a distribution from your 401(k) plan, the entire amount of your distribution will generally be taxable to you. This includes your contribution, any earnings, and any employer matching contributions.