401(k) Tips

Do you pay capital gains on 401k?

Different rules apply to capital gains generated from 401(k) investments. Find out how capital gains on 401(k) are taxed.

3 min read

When you contribute to a 401(k) account, these funds are allocated to various investment options like stocks, bonds, and mutual funds. Since a 401(k) is a tax-advantaged retirement account, you won’t pay tax on the contributions and capital gains from investments over your working years.

When your 401(k) money is invested in stocks, bonds, and mutual funds, these investments will generate capital gains over time. You won’t pay tax on the capital gains, and the investment earnings will grow tax-deferred over your working years until when you withdraw money in retirement. When you take a distribution, the money will be taxed at your income tax bracket, not the capital gains tax rate.

What is Capital Gain?

Capital gain is the appreciation in the value of an asset, and it is realized when an asset is sold. Usually, when you sell an asset at a higher value than you originally paid for it, you will have realized a capital gain. For 401(k) owners, capital gain occurs when the assets you hold in your portfolio like stocks, bonds, and real estate appreciate, and you realize a gain when you finally sell it.

The tax you pay on the capital gains depends on the duration you held the assets. Typically, capital gains can be grouped into either short-term or long-term capital gains. Short-term capital gains occur when assets are held for less than one year and are taxed as regular income. On the other hand, long-term capital gains occur when assets are held for more than one year before they are sold, and they are taxed based on graduated thresholds for taxable income at 0%, 15%, and 20%.

Capital gains tax on 401(k)

401(k) contributions are invested in various investments options such as stocks and mutual funds. These investments will grow over time and rack up capital gains. However, a 401(k) allows you to defer paying tax on capital gains, and you don’t have to pay taxes until when you withdraw money from the 401(k).

When you withdraw the money in retirement, any contributions, earnings, and long-term capital gains are taxed as ordinary income. This means that, even though you defer paying tax on capital gains, you won't benefit from the lower long-term capital gains rate. A majority of people pay a long-term capital gains tax of 15%, which could be lower than the ordinary income tax rate if the distribution occurred in a year of high income.

How 401(k) Money Gets Invested

A 401(k) plan is a defined-contribution plan where you and your employer contribute to a 401(k) account over your working life. A 401(k) account is funded with after-tax contributions, meaning you don’t pay tax on contributions until when you withdraw money in retirement.

401(k) contributions are pooled into various investment options to grow over time during the employee’s working years. Usually, the employer, also known as a 401(k) sponsor, handpicks investments options for the plan, and they may comprise stocks, bonds, money market investments, etc. The 401(k) participants then choose several funds to invest in from the available list of investment options. The most common investments are target-date funds, which may vary from conservative to aggressive income funds.

How 401(k) withdrawals are taxed

When you withdraw money from your 401(k), these withdrawals are considered an income. The total income is then summed up to determine the tax bracket your income falls in to determine your federal income tax rate. Some states may also impose taxes on 401(k) withdrawals, and you could pay taxes twice depending on the state where you reside.

If you are below age 59 ½, the 401(k) distributions will be considered an early withdrawal, and you should expect to pay a 10% penalty, in addition to the ordinary income taxes you will pay. However, some expenses may be exempted from the 10% penalty. For example, if the expense qualifies as a hardship withdrawal or you lost your job at 55, you won’t pay the 10% penalty.

How to Minimize Taxes on 401(k) Withdrawals

While you can’t avoid paying taxes on 401(k), there are certain things you can do to help you reduce the tax you pay on 401(k) withdrawals.

If you hold company stock in your 401(k), you can treat the stock appreciation as a capital gain instead of ordinary income. For long-term capital gains, you can be taxed at 0%, 15%, or 20%, depending on your tax bracket, which could be lower than your income tax bracket rate. To achieve this, you will need to transfer the company stock into a taxable brokerage account.

Another strategy to minimize the tax you pay on 401(k) withdrawals is to spread distributions over several years instead of taking a lump-sum distribution that will push you to a higher tax bracket. Taking small distributions over several years could put you at a lower tax bracket rate, hence a lower tax amount.