Small business owners can claim wages paid to employees as tax deduction. If one of his employees would elect to contribute $15K of his salary into 401(k) account then would the employer still be able to claim the portion contributed to 401(k) as tax deduction (i.e. on full wages)? If so, then wouldn't a single 401(k) contribution be tax deduction twice - once on employer's books and once on employee's books?

  • The employee and employer each still pay FICA and Medicare on that 15000. – user662852 Jan 11 '20 at 18:46

It is not a net deduction on the employee's books, because it is counted as income first and then removed from income when contributed to the 401(k), just as when the employee contributes to a traditional IRA. That is, the portion of wages that the employee contributes is neutral, neither increasing nor decreasing the employee's taxes.

EDIT: Yes, when an employee contributes part of their wages to a 401(k), those wages remain fully deductible by the employer:

You paid your employees wages but they chose to defer a portion of those wages into the 401(k). However, you still get a deduction for the full wage expense.

But I am trying to convey that there is not "tax relief twice for a single contribution". If the employer starts offering a 401(k) and the employee starts contributing part of their existing wages to it, the employee's taxes go down but the employer's taxes don't change. If the employer raises the employee's wages and the employee contributes that raise to the 401(k) -- keeping take-home pay the same -- then the employer's taxes go down but the employee's income taxes don't change. The contribution never generates a full net deduction for both parties at once.

  • It seems I did not use the term "tax deduction" correctly. Though can you affirmatively answer whether 401k contribution still gives benefit of full wage tax deduction to employer? It seems like could be a no-brainer for small business owners to offer 401k to their employees because there is tax relief twice for a single contribution. – user389238 Jan 11 '20 at 7:22
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    nanoman can confirm, but I believe the clear point is that wages are a deduction from an employer's income (i.e. an expense), but once paid to the employee, what they do with it is irrelevant. Unless, of course, the 401(k) is matched, then the 'matching' part is another expense/deduction for employer. – JTP - Apologise to Monica Jan 11 '20 at 12:32

Well, "deduction" is a bit imprecise. For the employee, it's an adjustment to income; as far as the IRS is concerned, it's money that the employee hasn't gotten yet. For the employer, it's an expense; it's part of the gross revenue, but not part of the net income. When lay people say "deduction", they usually are thinking about below-the-line deductions, and this is such to neither employee nor employer.

Another point to understand is that this isn't tax-free, it's tax-deferred. This is money that isn't going into the employee's pocket. It's going into a special account, and if the employee wants to spend it, they have to pay taxes on it.

So just how many incomes and deductions there are is to some extent a matter of accounting. If you want to treat it as a deduction to both employee and employer, you have to treat it as income to both. For instance, suppose I run a tutoring center, and a client pays me $30, and I then pay an employee $20, and the employee defers $5 of that into a 401(k) plan. That $5 can be analyzed as being a deduction for both me and my employee, but then it has to be analyzed as an income for both of us. If the employee then withdraws it from their 401(k) plan, that has to be considered a separate income under this analysis. That is, under this analysis, this $5 started out in the client's pocket. Then it went to me (gross revenue for me), then it went to my employee's 401(k) plan (income for them), then it went from the 401(k) account into the employee's bank account. Three income events, two deduction events.

We can also treat only the employee actually having access to the money as an income event for them, in which case we have two income events, and one deductions. Or we can not include it in my income, in which case it's two income events and one deduction again. We can do both, in which case one income event, and no deductions. Or we could go the other way. Maybe I contract to a school, and the school has $35 in funding that they used to hire my tutoring business. Then we could analyze it as four income events (the school gets funding, they pay me, I put the money in the employee's 401(k) account, the employee withdraws it), and three deductions.

No matter how you analyze it, there will be one more income event than deduction. Adding the employee to the analysis doesn't make the contribution any more effective; it can add a deduction to the analysis, but only if it also adds an income event.

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