Employer-sponsored retirement plans like a 401(k) are a common way for workers to save for retirement. In any given year, about half of employees participate in a retirement plan at work, according to the Bureau of Labor Statistics. So it’s important for participants to understand how 401(k) taxes work.
With a traditional 401(k) plan, employees can contribute a portion of their salary to an account with a range of investment options, including stocks, bonds, mutual funds, and cash.
Employers sometimes match part or all of these contributions. For instance, a company might match 50% of an employee’s contribution, up to 6% of the employee’s salary. In 2020 and 2021, participants can contribute up to $19,500 to a 401(k) plan, plus $6,500 if they’re 50 or older.
There are two main types of workplace 401(k) plans: a traditional plan and a Roth. Although Roth 401(k)s are a newer product on the market, they’re becoming increasingly popular. The rules on 401(k) taxes depend on which plan an employee participates in.
Traditional 401(k) Tax Rules
When it comes to this tried-and-true retirement savings plan, here are key things to know about 401(k) taxes and 401(k) withdrawal tax.
1. You Don’t Pay Taxes on Contributions
Your contributions to a 401(k) plan come from pretax income. If you’re contributing to your work 401(k), each time you are to receive a paycheck, a predetermined portion is deposited into your 401(k), and the rest is paid to you, less any taxes.
Because the money comes out of your paycheck before taxes, your paycheck will decrease by less than your total contribution.
How this might look:
• Your gross salary: $50,000
• Pay schedule: Every two weeks
• State/local tax rate: 6%
• Federal income tax rate: 22%
If you contribute 10% of your salary, $192 will be deducted from each paycheck (before taxes), but your take-home pay will decrease by only $138.
If you contribute 15% of your salary, $288 will be deducted from each paycheck (before taxes), but your take-home pay will decrease by only $208.
2. Your 401(k) Contributions Lower Your Taxable Income
The more you contribute to a 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 income.
How this might look:
• Your gross salary: $50,000
• State/local tax rate: 6%
• Federal income tax rate: 22%
If you contribute 0% of your salary annually, you’ll pay taxes on the full $50,000.
If you contribute 10% of your salary annually, $5,000 will be deposited into your 401(k) account and you will be taxed on $45,000. Total tax savings: $1,400.
If you contribute 15% of your salary annually, $7,500 will be deposited into your 401(k) account and you will be taxed on $42,500. Total tax savings: $2,100.
3. Withdrawals Are Taxable
When you take withdrawals from your 401(k) account in retirement, you’ll be taxed on both your contributions and any earnings that have accrued over time.
The withdrawals count as taxable income, so you will owe taxes in your retirement income tax bracket.
4. You’ll Pay Extra If You Withdraw the Money Early
If you withdraw money from your 401(k) before age 59½, you’ll owe both income taxes and a 10% tax penalty on the distribution.
Although IRAs allow penalty-free early withdrawals for qualified first-time homebuyers and for 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 in which they turn 55, they can start taking distributions from their 401(k) account without paying taxes or 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 have to pay interest (yes, to yourself) on the loan.
Roth 401(k) Tax Rules
Here are some tax rules about the newer retirement savings vehicle, the Roth 401(k).
5. You Pay Taxes on the Money Before Contributing
A Roth 401(k) works in the opposite way, tax-wise, from a traditional 401(k). Your contributions are post-tax, meaning you pay taxes on the money in the year in which you contribute it.
6. Contributions Do Not Lower Your Taxable Income
Although part of your paycheck will be deposited into a Roth 401(k), you’ll be taxed as though you received the entire amount. 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.
7. 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 the five-year rule is met, explained in No. 8).
No matter what your tax bracket is in retirement, qualified withdrawals from your Roth 401(k) won’t affect your taxable income.
8. There Are Limits on Withdrawals
In order for a withdrawal from a Roth 401(k) to count as a qualified distribution (i.e., no taxes), an employee must be at least age 59½ 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.
9. You Can Roll the Money Into a Roth IRA
Anyone who’s earning income can set up an individual retirement account. With a traditional IRA, investments in the account grow tax-deferred. A Roth IRA is funded with after-tax dollars, as is an employer-sponsored Roth 401(k) account.
Money in a Roth 401(k) account can be rolled into a Roth IRA.
One of the big differences between a Roth 401(k) and 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 sans taxes and penalty 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 then.
If you already have a Roth IRA established with contributions, the clock starts from the date of your first contribution to it.
If you’re thinking of establishing a Roth IRA in order to roll over your account in five years, keep in mind that you must meet income requirements to contribute to a Roth IRA.
10. Any Employer Match Must Go to a Different Account
If you have a Roth 401(k) and your company offers a 401(k) match, that matching contribution must go into a pretax account, which would be a traditional 401(k) account.
Optimizing Your Retirement Tax Planning
Understanding 401(k) tax rules and 401(k) tax benefits puts you in a position to take steps to minimize taxes overall. Here are some things to 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 expectations for your tax treatment in the future.
Your account mix: Having savings in different types of accounts—both pretax 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’s sometimes 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.
Your living plans: Seven U.S. states don’t charge individual income taxes at all: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. And Tennessee and New Hampshire only tax interest and dividend income. This can affect your tax planning if you live in a tax-free state now or if you 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. Making sure you’re saving enough, choosing appropriate investments, and understanding 401(k) tax rules are all part of the equation.
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