When is a 401k taxed?

One of the features that makes a 401(k) an attractive retirement account is the tax-deferred status. A 401(k) plan allows participants to contribute pretax dollars to their 401(k) account, and this amount is deducted from their paycheck each pay period. However, the tax-deferred status only postpones paying taxes, and you will still pay taxes at a future date.

A 401(k) is taxed when you withdraw money from the retirement account. You will pay taxes when you withdraw your 401(k) contributions and the earnings generated from your contributions. The 401(k) withdrawals will be taxed at your tax bracket rate in the year when you took the distribution. However, if you have a Roth 401(k), you will pay taxes on contributions, and any qualified distributions you take from the account will be tax-free.

Do you pay taxes on 401(k) contributions?

A 401(k) is a tax-deferred account, and you won’t pay taxes when you make contributions to the retirement account. Usually, the employer withholds the 401(k) contributions from your paycheck before the funds are subject to income taxes. This means that the contributions are taken off from your gross salary, hence reducing your taxable income.

For example, if you earn $90,000, and contribute $15,000 to a 401(k) plan, you will only pay taxes on $75,000. This means that you will report $75,000 when filing your annual return, and not the gross income of $90,000. Your employer will report the $75,000 on your W-2 Form, and you will not need to deduct the 401(k) contributions on your tax return, since the employer has already accounted for these contributions.

Although you won’t pay taxes on 401(k) contributions, you will still owe FICA taxes on your contributions to a 401(k). These taxes are calculated based on your full salary amount before you take out the 401(k) contributions.

How much taxes do you pay on 401(k) withdrawals?

Once you retire, you are allowed to start taking distributions from the 401(k) account. Since you have deferred paying taxes over your working years, you must pay taxes on the distributions you take from 401(k). The distributions are taxed as regular income at your tax bracket rate.

When taking distributions from your 401(k) account, you can opt to take gradual distributions or lump-sum distributions. A lump-sum distribution can push you to a higher tax bracket and you will owe more in income taxes. Since you have already paid FICA taxes, you won't pay these taxes again when you withdraw money from the 401(k).

If you don't need the money immediately, you can wait until you attain the age for the required minimum distributions. The IRS requires that, once you turn 72, you must start taking the required distributions based on the life expectancy tables. 

Also, some states may charge income taxes on 401(k) distributions. The amount of taxes you pay will depend on the tax rates imposed in your state. If you live in a state with no income taxes, you won’t be required to pay state income taxes on 401(k) distributions.

Taxes on early withdrawals from 401(k)

The IRS requires that you must be at least 59 ½ to take distributions from 401(k). Withdrawals before age 59 ½ are considered early withdrawals and are subject to a 10% penalty tax, in addition to the ordinary income taxes that you will owe. The employer may also withhold 20% of the distribution for taxes.

However, you may be able to avoid the 10% penalty for early withdrawals from 401(k) if you qualify for an exemption. Some of the expenses that qualify for an exemption include unreimbursed medical expenses, permanent disability, when you give birth or adopt a child, pay IRS levy, substantially equal periodic payments, or when you die. If you qualify for the exemption, only the 10% penalty tax will be waived- you will still be required to pay income taxes on the withdrawal.

Taxes on Roth 401(k)

Roth 401(k) has a different tax treatment from a traditional 401(k). A Roth 401(k) is funded with post-tax dollars, and this means taxes are taken out at the time of contribution. Hence, you won’t get a tax deduction on the Roth 401(k) contributions. Since you have already paid taxes on Roth 401(k) contributions, you won’t be required to pay taxes on Roth 401(k) distributions, as long as the distributions are qualified.

For a Roth 401(k) distribution to be qualified, the account must be at least five years old since the first contribution, and you must be at least age 59 ½ or older. If you are above age 59 ½ but the account is not sufficiently aged, withdrawals from the account will be considered non-qualified, and you will still owe income taxes on the distributions.

Qualified and non-qualified distribution rules only apply to investment earnings generated by the Roth 401(k). You can withdraw the contributions from the Roth 401(k) at any time without taxes and penalties. However, the investment earnings must be reported when filing the annual tax return.

Taxes on 401(k) rollover

There are different tax implications when you transfer funds from a 401(k) into a new employer’s 401(k) or IRA. If you rollover over from a 401(k) into another retirement account via direct rollover, you won’t owe taxes on the rollover. A direct rollover involves moving the 401(k) funds from one custodian to another without the money going through your hands.

If you opt for an indirect rollover, you must transfer the rollover funds to another retirement account within 60 days to avoid taxes. If you complete the rollover within 60 days, you won't owe taxes and penalties on the withdrawal. However, if you don't complete the rollover within 60 days, the amount withdrawn will be added to your gross income, and you will pay income taxes on the money. If you are below age 59 ½, you will also owe a 10% penalty on the withdrawal.