401(k) Tax Implications: What You Need to Know
When it comes to saving for retirement, it may be not just about how much you save – it may be about how much you get to keep.
Understanding 401(k) tax implications may help you maximize your savings and avoid unexpected tax bills down the road.
Are you aware of how your 401(k) contributions affect your taxable income? Or what taxes you’ll owe when you withdraw funds in retirement?
Keep reading to learn tax rules that could impact your 401(k) savings.
#1 Tax-Deferred Contributions
Contributions to a traditional 401(k) are made pre-tax, meaning they may reduce your taxable income in the year you contribute.
This means you don’t pay income taxes on the contributions immediately.
You get a tax break for every dollar that you invest into your 401(k) with pre-tax dollars.
For example, if you earn $50,000 and contribute 3% ($1,500) to your 401(k), your taxable income drops to $48,500.
In some cases, your 401(k) contributions may even push you into a lower tax bracket, reducing your overall tax liability.
Note that, even though 401(k) contributions reduce taxable income, they don’t reduce FICA taxes – which fund Social Security and Medicare.
Your payroll taxes are calculated based on your full paycheck amount, including your 401(k) contributions.
This is important to keep in mind because Social Security was never meant to fully fund retirement – and relying on it alone isn’t a smart strategy.
[Related Read: Are You Saving Enough to Cover These Retirement Expenses?]
#2 No Deductions Needed on Your Tax Return
You don’t need to report 401(k) contributions as deductions when filing your taxes.
Since contributions are taken directly from your paycheck before taxes, your W-2 will already reflect a lower taxable income.
#3 Tax-Deferred Growth
One of the advantages of a traditional 401(k) is that your investments grow tax-deferred – meaning you don’t pay taxes on earnings until you withdraw them.
Your money benefits from compound growth, where you earn returns on both your initial contributions and past earnings.
The longer your money is invested, the more it may grow.
Keep in mind that 401(k) plan participants may rebalance their assets to take advantage of potential growth opportunities, which means this could boost your savings even more!
[Related Read: 5 Perks of Saving for Retirement in a 401(k)]
#4 Employer Contributions Are Tax-Deferred
Employer matching contributions aren’t taxed when deposited, but are taxed when withdrawn in retirement.
Matching contributions count toward your total 401(k) balance, but they don’t count toward your personal contribution limit.
[Related Read: 4 Ways to Potentially Maximize Your 401(k) Company Match]
#5 Roth 401(k) Contributions
The Roth 401(k) is a type of 401(k) that you fund just like a traditional 401(k).
The main difference is that you either get a tax break today with the traditional 401(k), or tax-free withdrawals in retirement with the Roth 401(k) since your contributions are made with after-tax dollars today.
If you contribute to the Roth 401(k), you won’t get a tax break since contributions are made with after-tax dollars.
Whether or not this is a downside is ultimately up to the individual.
Some people need a tax break today, while others aren’t concerned with it and would rather have their retirement be tax-free.
[Related Read: Should I Consider the Roth 401(k)?]
#6 Taxes on 401(k) Withdrawals
Once you retire and start withdrawing money from your traditional 401(k), those withdrawals are taxed as ordinary income in the year you take them.
If you want to take a withdrawal from your 401(k), you need to be at least age 59½ to avoid paying an early withdrawal penalty to the IRS.
These early withdrawals are subject to ordinary income tax on the amount you withdraw plus a 10% early withdrawal penalty.
#7 Taxes on Early Withdrawals
Withdrawing money from a 401(k) before age 59½ may result in penalties and taxes on the withdrawals.
The IRS requires automatic withholding of 20% of a 401(k) withdrawal.
Along with the withholding taxes, the IRS will most likely also hit you with a 10% penalty if you’re under the age of 59½ on all funds withdrawn when you file your tax return.
The amount withdrawn is commonly taxed as ordinary income for the year the money was taken out, which could push you into a higher tax bracket and force you to pay even more taxes.
Let’s say you’re under 59½ and you withdraw $15,000 from your 401(k).
You will wind up having 20% plus the penalty withheld, leaving you with only about $10,500 of the $15,000 early withdrawal.
[Related Read: 401(k) Early Withdrawals May Cost You More Than You Think]
#8 Tax Benefits in Retirement
When you start withdrawing funds from your traditional 401(k) during retirement, you can expect to pay taxes on both the contributions and the earnings, and they are subject to ordinary income tax rates.
However, the tax benefits of a 401(k) plan are designed to help you save for retirement.
By deferring taxes until retirement, you may be in a lower tax bracket than you would have been when you initially made the contributions.
This results in a lower tax bill on withdrawals.
[Related Read: Pros and Cons of a Roth 401(k): Key Differences and Tax Implications]
Get Professional Advice for 401(k) Tax Planning
Understanding 401(k) tax rules is important when it comes to keeping more of your money in retirement.
But navigating tax strategies can be tricky.
Consult with a CPA or accountant to ensure you’re making tax-smart decisions based on your specific financial situation.
This is your retirement we’re talking about – and every dollar you keep can help.
In addition, seek help from a financial advisor to determine how to get the most out of your 401(k) plan.
