What are taxes on a 401(k)?

A 401(k) is a tax-deferred account, and employees are not required to pay income taxes on their contributions. You will still be required to pay FICA taxes i.e. Social Security and Medicare Taxes. If you make a withdrawal, you will be required to pay income taxes on the withdrawal amount, and a penalty tax if you are below 59 ½.

For most retirement savers, 401(k) provides a way to reduce income taxes on the paycheck. However, you don't avoid paying taxes forever. Instead, your tax bill comes when you make a withdrawal, and the 401 (k) tax you pay depends on your age and income level.  

Do You Pay Tax on 401(k) Contributions?

One of the advantages of using a 401(k) to accumulate retirement savings is the tax break you get on your contributions. For example, if your annual income is $60,000, and you contributed $7,000 into a 401(k) account, your taxable income is $53,000. This is the amount that will be subjected to income taxes at your tax bracket rate.

Usually, there is a government limit on how much you can contribute towards your 401(k) due to the tax breaks. In 2020 and 2021, there is a limit of $19,500 for people below 50, or $26,000 for those 50 or older. This limit is per person, and it applies to all your 401(k) account contributions.

When reporting your annual income, you should not deduct the 401(k) contributions again. Your employer will send you a W-2 Form that indicates your 401(k) contributions for the previous year. However, the IRS will still deduct FICA taxes (Medicare and Social Security taxes) on your gross income (inclusive of your 401(k) contributions).

Tax Treatment of Roth 401(k) Contributions

A Roth 401(k) account is a special 401(k) plan, and it has different tax treatment rules compared to the traditional 401(k) plan. A Roth 401(k) plan is funded with after-tax dollars, and the IRS deducts taxes on the contributions you make to the plan. Withdrawal of contributions in retirement is made tax-free, as long as the IRS considers these distributions qualified.

Tax Charged on 401(k) Distributions

A withdrawal from a 401(k) is known as a distribution in “IRS lingo”. When you take a 401(k) distribution, the distribution will only be subject to income taxes. For example, if you withdraw $4000, you will only pay income tax on that $4000 in retirement. FICA taxes only apply during your active working years. However, how much you pay as income tax depends on how and when you take a distribution.

When you are 59 ½, you can start taking distributions without paying a penalty tax. For a Roth 401(k) account, the withdrawals you make are not taxed, since you already paid income taxes when putting money into the account. You can start taking penalty-free and tax-free distributions from a Roth 401(k) account once you are at least 59 ½.

Once you hit 72 and already retired, you will be required to start taking the required minimum distributions. If you delay in taking the minimum distribution after age 72, IRS will impose a 50% penalty of the amount not distributed.

Tax Charged on Early Withdrawal

Your 401(k) retirement savings are meant to help you pay for expenses in your golden years. Taking out a distribution before you are 59 ½ is a bad idea, and it will trigger a 10% penalty on the withdrawal amount. This means you will pay a penalty tax in addition to income taxes.

The tax consequences of an early withdrawal before age 59 ½ include:

• 10% Penalty; The IRS will assess a 10% penalty on the distribution. If you withdraw $10,000, the IRS will take a 10% cut from your withdrawal amount i.e. $1000
•  20% withholding tax: The IRS requires employers to withhold 20% of the 401(k) early withdrawal for payment of income taxes. If you withdraw $10,000 before you are 59 ½, your employer will withhold $2000, and you will receive $8000.

Exemptions for the 10% Early Withdrawal Penalty

The IRS may provide an exemption to the 10% penalty for early 401(k) withdrawal in certain circumstances. Some of these circumstances include:

• Medical expenses that exceed 7.5% of the Adjusted Gross Income
• Buying a first home
• You become completely disabled
• You are 55, and you retire, quit, or get fired from your job
• Qualify for a hardship distribution

These events only waive the 10% penalty, but not the income taxes. You must report the withdrawal amount in the tax return for the year.

Rolling Over a 401(k) Account

If you leave your employer, you may decide to transfer the retirement savings from the former employer’s 401(k) account into another retirement account. Here are the two options you have:

Rollover 401(k) to a new 401(k)

If you leave your job for a new job with another employer, you can transfer your 401(k) to the new employer's 401(k). Ask your employer or 401(k) plan administrator to transfer the funds directly to your new 401(k) plan. You can also ask the employer to write you a check, which you will deposit to the new 401(k). There is a 60-day window when you must deposit the funds in the new 401(k) plan to avoid paying taxes.

Rollover 401(k) to an IRA

When rolling over to an IRA, you have a choice of making a direct rollover or an indirect rollover. A direct rollover involves transferring the funds from the 401(k) provider to the financial institution or brokerage managing your IRA. You do not get your hands on the money, and the funds will not be subjected to income taxes.

For an indirect rollover, you can request the 401(k) plan administrator to mail you a check with your 401(k) money. You must transfer the funds into an IRA within 60 days from the date of transfer to avoid paying income taxes and penalties. The amount you receive from your 401(k) plan is less 20% withheld taxes, and you must come up with the entire amount (including the 20% withheld taxes) and deposit it in the IRA account within the 60 days.

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