What is the impact of tax-deferred contributions on a traditional 401(k)?

In a traditional 401(k), contributions made by the employee are deducted from their taxable income for the year in which they are made. This tax-deferred status means that individuals can reduce their current taxable income by the amount they contribute, which can lead to a lower overall tax liability for that tax year. This is particularly beneficial since it allows individuals to allocate more money toward their retirement savings while deferring taxes until they withdraw funds in retirement, ideally when they may find themselves in a lower tax bracket.

While contributions do grow tax-deferred until withdrawal, which is a key feature of a 401(k), the specific wording of the correct answer emphasizes the immediate effect of the contributions on taxable income. Options stating that contributions are taxed at a higher rate or can be withdrawn without penalty do not accurately describe the nature of contributions to a traditional 401(k) and the tax implications associated with them. Thus, the focus on the role of contributions in lowering taxable income is the vital point that underlines the impact of tax-deferred contributions on a traditional 401(k).