401(k) Tax Guide: Contributions, Withdrawals And More

No matter what stage of your career you’re in, understanding the tax implications of contributions to a 401(k) and withdrawals from a 401(k) is always a good idea. Just started your first job? Getting close to retirement? Somewhere in the middle of your career? No matter where you fall, it’s never too early – or too late – to think about your 401(k) and how to set it up to serve you well as you build toward your golden years.

The 411 On 401(k) Taxes

A 401(k), which gets its moniker from the section of the tax code it is found under, is a retirement plan that some employers sponsor for their employees. While you’re investing a portion of your paycheck into your 401(k) each payday, your employer may match a certain percentage of your contributions as well.

401(k)s come in many shapes and sizes, so be sure to research what exact type your employer makes available to you. For example, some 401(k) plans allow you to defer tax payments on the funds you invest until you withdraw, while others let you pay the tax on the money as you contribute to it each time you get a paycheck.

Taxes On 401(k) Contributions

In most cases, any contributions you make to your 401(k) account, as well as any amount your employer matches, aren’t taxed until you withdraw the funds from the account. The timing around when you take the money out is critical. You could end up paying more in taxes if you withdraw money from your 401(k) plan before retiring and reaching a certain age.

Taxes On 401(k) Withdrawals

401(k) withdrawals, also known as distributions, occur when you take money out of your account to use as income during retirement. How these withdrawals are taxed depends on your age and financial situation. Regardless of age or when you withdraw, taxes will need to be paid. That said, the amount you pay can vary greatly.  Let’s look at how this breaks down.

At What Age Is 401(k) Withdrawal Tax-Free?

Withdrawing funds early means paying an additional tax penalty. You can make penalty-free withdrawals from your 401(k) starting at age 59½. Withdrawal earlier and you’ll be on the hook for an early withdrawal penalty.

Taxes For Early 401(k) Withdrawals

How much more will you pay if you dip into your retirement early? If you withdraw from your 401(k) account before age 59½, the IRS will assess a 10% tax penalty on all the funds you withdraw. The IRS also treats the withdrawals as regular income, so you will have to pay income tax on the money on top of the early withdrawal penalty.

There are some circumstances in which you could withdraw funds early without paying the 10% penalty if you’re facing financial hardships. According to the IRS, the circumstances must present an “immediate and heavy financial need.” Some scenarios that meet this definition include: 

●      Expenses related to purchasing your primary residence, but not including your mortgage payments

●      Expenses to repair damage to your primary residence

●      Payments needed to avoid eviction or foreclosure on your primary residence

●      Medical expenses for yourself, your spouse, your children or any of your dependents

●      Postsecondary education (college, trade schools, etc.) tuition for yourself, spouse, children or dependents

●      Funeral expenses

401(k) Withdrawal Tax For Retirees

If you’re above the age of 59½ and are ready to enjoy your retirement, you can start making qualified withdrawals from your 401(k) account. You are not required to start withdrawing from your 401(k) at 59½, but there will come a time when you must start taking required minimum distributions (RMDs). Generally, you must begin withdrawing funds when you reach age 72. The amount you must withdraw every year depends on how much money you have in your 401(k) and your life expectancy, defined by the IRS’s “Uniform Lifetime Table.”

Taxes On A Roth 401(k) Plan

You may have heard the term “Roth” in relation to 401(k) plans and are wondering what that means and how it differs from a traditional 401(k). A Roth 401(k) is another form of employer-sponsored retirement account that is slightly different from a traditional 401(k). When you contribute to a Roth 401(k), you pay income tax on the money upfront. That means you can withdraw the funds tax-free at retirement. Age 59½ is the penalty-free threshold for a Roth 401(k), just like a traditional 401(k). 

Traditional 401(k) Vs. Roth 401(k)

Choosing between these retirement account options if your employer offers both can be tricky. Here’s a breakdown to help you make the best decision for your own individual situation.

Traditional 401(k) Vs. Roth 401(k)

Choosing between these retirement account options if your employer offers both can be tricky. Here’s a breakdown to help you make the best decision for your own individual situation.

Taxes On A 401(k) Rollover

When you leave the company that sponsors your 401(k) plan, you cannot continue making contributions to that plan, but you can conduct a 401(k) rollover. A rollover transfers the funds tax-free from your old 401(k) into your new company’s 401(k) plan, or into an independent retirement account (IRA). This allows you to continue to build on it without getting the tax hit you would get with an early withdrawal.

5 Tips For Reducing Your 401(k) Taxes

You want to get the most out of your 401(k), which means minimizing the amount of taxes you pay on it. Since the amount of 401(k) taxes you pay largely depends on your tax bracket, many of the strategies focus on avoiding entering a higher tax bracket. It’s always a good idea to speak with a financial advisor who can provide the best strategy based on your specific situation, but here are a few key things to consider in the meantime.

1. Plan Carefully

Plan ahead to avoid early withdrawals from a 401(k) account. Sometimes “life happens” and you need to access the funds, but planning ahead can help reduce the risk of needing an early withdrawal. If withdrawing money early becomes unavoidable, talk to a financial advisor about ways you might qualify for an early withdrawal without a penalty.

2. Consider A 401(k) Loan Vs. An Early Withdrawal

401(k) loans are one possible way to avoid the taxes that come with an early 401(k) withdrawal. Note any rules associated with paying back 401(k) loans. Keep in mind that if you fail to pay off the loan the unpaid amount will come out of your 401(k) and will count as an early withdrawal, and the amount will be taxed.

3. Look Into Tax-Loss Harvesting

Another way you might be able to offset some 401(k) taxes associated with an early withdrawal is through tax-loss harvesting. This entails taking investment gains that are taxable and selling them at a loss, also sometimes referred to as “harvesting” them. This is most beneficial for people in higher tax brackets as it helps investors offset capital gains on one asset over another. If this sounds like a good strategy to you, we highly recommend working with your financial manager or tax consultant before making these moves.

4. Monitor Your Tax Bracket

Speaking of your tax bracket, limit your 401(k) withdrawals to avoid being placed into a higher one. This could be the single most impactful way to make sure you get the most out of your 401(k). Consult with your financial advisor about where you fall in the tax bracket structure and what forms of income might bump you up to a new one that is more heavily taxed. You could also consider increasing your contribution to your retirement accounts now, assuming you will be in a lower tax bracket when you withdraw money in retirement.

5. Consult A Tax Expert

Hopefully you’ve learned a lot here and, of course, doing more research on 401(k) taxes beyond this article is a good idea. That said, there is no substitution for getting advice from a professional. Find a competent tax professional you trust and tell them about your specific situation so they can recommend the best ways for you to maximize your 401(k) accounts and avoid tax penalties.

The Bottom Line

Avoiding tax penalties and not damaging the 401(k) savings you have work hard for is a great way to set yourself up for retirement. Need a little help staying informed and prepared? Download the Rocket Money℠ app today to stay up to date on your retirement savings accounts and more.