Employer-sponsored retirement plans like a 401(k) are a common way for workers to save for retirement. According to the Bureau of Labor Statistics, a little more than half of private industry employees participate in a retirement plan at work. So participants need to understand how 401(k) taxes work to take advantage of this popular retirement savings tool.
With a traditional 401(k) plan, employees can contribute a portion of their salary to an account with various investment options, including stocks, bonds, mutual funds, exchange-traded funds (ETFs), and cash.
There are two main types of workplace 401(k) plans: a traditional 401(k) plan and a Roth 401(k). The 401(k) tax rules depend on which plan an employee participates in.
Traditional 401(k) Tax Rules
When it comes to this employer-sponsored retirement savings plan, here are key things to know about 401(k) taxes and 401(k) withdrawal tax.
401(k) Contributions are Made With Pre-tax Income
One of the biggest advantages of a 401(k) is its tax break on contributions. When you contribute to a 401(k), the money is deducted from your paycheck before taxes are taken out, which reduces your taxable income for the year. This means that you’ll pay less in income tax, which can save you a significant amount of money over time.
If you’re contributing to your company’s 401(k), each time you receive a paycheck, a self-determined portion of it is deposited into your 401(k) account before taxes are taken out, and the rest is taxed and paid to you.
For 2023, participants can contribute up to $22,500 to a 401(k) plan, plus $7,500 in catch-up contributions if they’re 50 or older. These contribution limits are up from 2022, when the limit was $20,500, plus the additional $6,500 for those aged 50 and up.
401(k) Contributions Lower Your Taxable Income
The more you contribute to your 401(k) account, the lower your taxable income is in that year. If you contribute 15% of your income to your 401(k), for instance, you’ll only owe taxes on 85% of your income.
Withdrawals From a 401(k) Account Are Taxable
When you take withdrawals from your 401(k) account in retirement, you’ll be taxed on your contributions and any earnings accrued over time.
The withdrawals count as taxable income, so during the years you withdraw funds from your 401(k) account, you will owe taxes in your retirement income tax bracket.
Early 401(k) Withdrawals Come With Taxes and Penalties
If you withdraw money from your 401(k) before age 59 ½, you’ll owe both income taxes and a 10% tax penalty on the distribution.
Although individual retirement accounts (IRAs) allow penalty-free early withdrawals for qualified first-time homebuyers and qualified higher education expenses, that is not true for 401(k) plans.
That said, if an employee leaves a company during or after the year they turn 55, they can start taking distributions from their 401(k) account without paying taxes or early withdrawal penalties.
Can you take out a loan or hardship withdrawal from your plan assets? Many plans do allow that up to a certain amount, but withdrawing money from a retirement account means you lose out on the compound growth from funds withdrawn. You will also have to pay interest (yes, to yourself) on the loan.
Roth 401(k) Tax Rules
Here are some tax rules for the Roth 401(k).
Your Roth 401(k) Contributions Are Made With After-Tax Income
When it comes to taxes, a Roth 401(k) works the opposite way of a traditional 401(k). Your contributions are post-tax, meaning you pay taxes on the money in the year you contribute.
If you have a Roth 401(k) and your company offers a 401(k) match, that matching contribution will go into a pre-tax account, which would be a traditional 401(k) account. So you would essentially have a Roth 401(k) made up of your own contributions and a traditional 401(k) of your employer’s contributions.
Recommended: How an Employer 401(k) Match Works
Roth 401(k) Contributions Do Not Lower Your Taxable Income
When you have Roth 401(k) contributions automatically deducted from your paycheck, your full paycheck amount will be taxed, and then money will be transferred to your Roth 401(k).
For instance, if you’re making $50,000 and contributing 10% to a Roth 401(k), $5,000 will be deposited into your Roth 401(k) annually, but you’ll still be taxed on the full $50,000.
Roth 401(k) Withdrawals Are Tax-Free
When you take money from your Roth 401(k) in retirement, the distributions are tax-free, including your contributions and any earnings that have accrued (as long as you’ve had the account for at least five years).
No matter what your tax bracket is in retirement, qualified withdrawals from your Roth 401(k) are not counted as taxable income.
There Are Limits on Roth 401(k) Withdrawals
In order for a withdrawal from a Roth 401(k) to count as a qualified distribution — meaning, it won’t be taxed — an employee must be age 59 ½ or older and have held the account for at least five years.
If you make a withdrawal before this point — even if you’re age 61 but have only held the account since age 58 — the withdrawal would be considered an early, or unqualified, withdrawal. If this happens, you would owe taxes on any earnings you withdraw and could pay a 10% penalty.
Early withdrawals are prorated according to the ratio of contributions to earnings in the account. For instance, if your Roth 401(k) had $100,000 in it, made up of $70,000 in contributions and $30,000 in earnings, your early withdrawals would be made up of 70% contributions and 30% earnings. Hence, you would owe taxes and potentially penalties on 30% of your early withdrawal.
If the plan allows it, you can take a loan from your Roth 401(k), just like a traditional 401(k), and the same rules and limits apply to how much you can borrow. Any Roth 401(k) loan amount will be combined with outstanding loans from that plan or any other plan your employer maintains to determine your loan limits.
You Can Roll Roth 401(k) Money Into a Roth IRA
Money in a Roth 401(k) account can be rolled into a Roth IRA. Like an employer-sponsored Roth 401(k), a Roth IRA is funded with after-tax dollars.
One of the significant differences between a Roth 401(k) and a Roth IRA is that the 401(k) requires participants to start taking required minimum distributions at age 72, but there is no such requirement for a Roth IRA.
It’s important to note, however, that there’s also a five-year rule for Roth IRAs: Earnings cannot be withdrawn tax- and penalty-free from a Roth IRA until five years after the account’s first contribution. If you roll a Roth 401(k) into a new Roth IRA, the five-year clock starts over at that time.
Do You Have to Pay Taxes on a 401(k) Rollover?
If you do a direct rollover of your 401(k) into an IRA or another eligible retirement account, you generally won’t have to pay taxes on the rollover. However, if you receive the funds from your 401(k) and then roll them over yourself within 60 days, you may have to pay taxes on the amount rolled over, as the IRS will treat it as a distribution from the 401(k).
Recommended: How to Roll Over Your 401(k)
Do You Have to Pay 401(k) Taxes after 59 ½?
If you have a traditional 401(k), you will generally have to pay taxes on withdrawals after age 59 ½. This is because the money you contributed to the 401(k) was not taxed when you earned it, so it’s considered income when you withdraw it in retirement.
However, if you have a Roth 401(k), you can withdraw your contributions and earnings tax-free in retirement as long as you meet certain requirements, such as being at least 59 ½ and having had the account for at least five years.
Do You Pay 401(k) Taxes on Employer Contributions?
The taxation of employer contributions to a 401(k) depends on whether the account is a traditional or Roth 401(k).
In the case of traditional 401(k) contributions, the employer contributions are not included in your taxable income for the year they are made, but you will pay taxes on them when you withdraw the funds from the 401(k) in retirement.
In the case of Roth contributions, the employer contributions are not included in a post-tax Roth 401(k) but rather in a pre-tax traditional 401(k) account. So, you do not pay taxes on the employer contributions in a Roth 401(k), but you do pay taxes on withdrawals.
How Can I Avoid 401(k) Taxes on My Withdrawal?
The only way to avoid taxes on 401(k) withdrawals is to take advantage of a Roth 401(k), as noted above. With a Roth 401(k), your contributions are made post-tax, but withdrawals are tax-free if you meet certain criteria to avoid the penalties mentioned above.
However, even if you have to pay taxes on your 401(k) withdrawals, you can take the following steps to minimize your taxes.
Consider Your Tax Bracket
Contributing to a traditional 401(k) is essentially a bet that you’ll be in a lower tax bracket in retirement — you’re choosing to forgo taxes now and pay taxes later.
Contributing to a Roth 401(k) takes the opposite approach: Pay taxes now, so you don’t have to pay taxes later. The best approach for you will depend on your income, your tax situation, and your future tax treatment expectations.
Strategize Your Account Mix
Having savings in different accounts — both pre-tax and post-tax — may offer more flexibility in retirement.
For instance, if you need to make a large purchase, such as a vacation home or a car, it may be helpful to be able to pull the income from a source that doesn’t trigger a taxable event. This might mean a retirement strategy that includes a traditional 401(k), a Roth IRA, and a taxable brokerage account.
Decide Where To Live
Eight U.S. states don’t charge individual income tax at all: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. And New Hampshire only taxes interest and dividend income.
This can affect your tax planning if you live in a tax-free state now or intend to live in a tax-free state in retirement.
Saving for retirement is one of the best ways to prepare for a secure future. And understanding the tax rules for 401(k) withdrawals and contributions is essential for effective retirement planning. By educating yourself on the rules and regulations surrounding 401(k) taxes, you can optimize your retirement savings and minimize your tax burden.
Another strategy to help stay on top of your retirement savings is to roll over a previous 401(k) to a rollover IRA. Then you can manage your money in one place.
SoFi makes the rollover process seamless. The process is automated so there’s no need to watch the mail for your 401(k) check — and there are no rollover fees or taxes.
Do you get taxed on your 401(k)?
You either pay taxes on your 401(k) contributions — in the case of a Roth 401(k) — or on your traditional 401(k) withdrawals in retirement.
When can you withdraw from 401(k) tax free?
You can withdraw from a Roth 401(k) tax-free if you have had the account for at least five years and are over age 59 ½. With a traditional 401(k), withdrawals are generally subject to income tax.
How can I avoid paying taxes on my 401(k)?
You never truly avoid paying taxes on a 401(k), as you either have to pay taxes on contributions or withdrawals, depending on the type of 401(k) account. By contributing to a Roth 401(k) instead of a traditional 401(k), you can withdraw your contributions and earnings tax-free in retirement.
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Update: The deadline for making IRA contributions for tax year 2020 has been extended to May 17, 2021.