Since its inception in 1978, the 401(k) plan has grown to become the most popular type of employer-sponsored retirement plan in America. Millions and millions of workers depend on the money they invest in these plans to provide for them in their retirement years. Many employers also see a 401(k) plan as a key benefit of the job.
For all those who don’t know what the 401(k) plan is or never even heard of it, trust us, it is something you must know about no matter you are an employee or an employer. So, to help you understand the concept of the 401(k) plan we have this article ready for you, where we discuss some of the major tax rules and more under the 401(k) plan.
This article will cover the following:
- What is a 401(k) plan?
- What is the importance of a 401(k) plan?
- What are the taxes on 401(k) plan contributions?
- What are the taxes on 401(k) plan distributions?
- What are the taxes on employer contributions?
- What are the deductions on the 401(k) plan?
- What are the taxes on different types of 401(k) plans?
- What are the taxes on rolling over a 401(k) plan?
- What are the ways to reduce 401(k) plan taxes?
What is 401(k)?
A 401(K) plan is popularly known as an employer-sponsored retirement plan to which certain eligible employees based on pre-set criteria can make tax-deferred contributions from their salary or wages.
Like the EPF (Employees Provident Fund) contributions in India, in the 401K plan also the employee and the employer contribute to the plan. However, there is a difference here.
In India, the employer contribution and the employee contribution to EPF are tax-free in the hands of the employee. On the other hand, in the 401K plan, only the employee contribution is tax-free. In other words, the employee contribution is post-tax while the employer contribution is pre-tax.
Employers offering a 401(K) plan may make matching or non-elective contributions to the plan on behalf of eligible employees and are also permitted to add a profit-sharing feature to the plan.
In the Indian EPF plan, the benefits of 401K are also tax-deferred which means the full benefits are only realized at the time of retirement and regular payments are credited to the plan and cannot be withdrawn. Hence, the tax burden you’ll incur varies by the type of 401(K) and on how and when you withdraw funds from it.
What is the Importance of 401(k)?
401k plans are one of the most common investment vehicles that Americans use to save for retirement.
If you add your own numbers into the calculation and find out that you won't have enough retirement income, you'll need to save more aggressively. That's where your 401(k) assumes even greater importance, as it can be a much more effective savings tool than an IRA.
In 2021, you can contribute to a 401(k), an annual maximum amount of $19,500 for 2021 and $20,500 for 2022. If you are age 50 or older, you can contribute an extra $6,500 via a catch-up contribution in both 2021 and 2022. However, for an IRA in 2021 and 2022, the annual contribution limit is only $6,000, plus another $1,000 if you are 50 or older. An advantage that you cannot ignore is that 401(k) has considerably higher contribution limits as compared to IRA.
Always try to put enough money into your 401k to receive your full employer match; if you decide not to put in at least enough money to get the full employer match for your 401k then you are essentially forfeiting free money for a comfortable future.
What are the Taxes on 401(k) Contributions?
A 401(k) is a tax-deferred account. That means you do not pay income taxes when you contribute money. Instead, your employer withholds your contribution from your paycheck before the money can be subjected to income tax.
As you choose investments within your 401(k) and as those investments grow, you also do not need to pay income taxes on the growth. Instead, you defer paying those taxes until you withdraw the money.
Keep in mind that while you do not have to pay income taxes on the money you contribute to a 401(k), you still pay FICA taxes, which go toward Social Security and Medicare. That means that the FICA taxes are still calculated based on the full paycheck amount, including your 401(k) contribution.
In 2021, you can contribute up to $19,500 a year to a 401(k) plan. If you’re 50 or older, you can contribute $26,000. In 2022, the contribution limit increases to $20,500 a year. If you're 50 or older, you can contribute $27,000. The annual contribution limit is per person, and it applies to all of your 401(k) account contributions in total.
You still have to pay some FICA taxes (Medicare and Social Security) on your payroll contributions to a 401(k). Your employer will send you a W-2 in January that shows how much it paid you during the previous calendar year, as well as how much you contributed to your 401(k) and how much withholding tax you paid.
What are the Taxes for Making an Early Withdrawal From a 401(k)?
The minimum age when you can withdraw money from a 401(k) is 59 ½. Withdrawing money before that age results in a penalty worth 10% of the amount you withdraw. This is in addition to the federal and state income taxes you pay on this withdrawal. There are a few exceptions to this early-withdrawal penalty, though.
If you want to remove money from a 401(k) account without paying taxes, you will need to meet certain criteria. According to the IRS, you generally don’t have to pay income tax or an early withdrawal penalty if you experience “an immediate and heavy financial need.”
One situation where this may apply is when you have medical expenses that aren’t reimbursed by your insurance and which exceed 10% of your adjusted gross income. If this happens, you don’t have to pay taxes on the money you withdraw to cover that financial need.
There are also other exceptions, such a for disabled taxpayers. The IRS provides a more complete list of situations where you won’t pay tax on early withdrawals. The big warning here is that the amount you can withdraw tax-free is exactly enough to cover the cost of this financial need. And you’ll still pay the full income tax on your withdrawal; only the 10% penalty is waived.
- Taxes will be withheld. The IRS generally requires automatic withholding of 20% of a 401(k) early withdrawal for taxes. So if you withdraw the $10,000 in your 401(k) at age 40, you may get only about $8,000.
- The IRS will penalize you. If you withdraw money from your 401(k) before you’re 59½, the IRS usually assesses a 10% penalty when you file your tax return. That could mean giving the government another $1,000 of that $10,000 withdrawal.
- You will have less money for later, especially if the market is down when you start making withdrawals. That could have long-term consequences.
You might be able to escape the IRS’s 10% penalty for early withdrawals from a traditional 401(k) if you:
- Receive the payout over time.
- Use the money to pay certain medical expenses.
- Were a disaster victim.
- Over contributed to your 401(k).
- Were in the military.
- Qualify for a hardship distribution with the plan administrator.
- Leave your job and are over a certain age.
- Are getting divorced.
- Give birth to a child or adopt a child.
- Are or become disabled.
- Put the money in another retirement account.
- Use the money to pay an IRS levy.
For traditional 401(k)s, the money you withdraw (also called a “distribution”) is taxable as regular income, like income from a job in the year you take it. (Remember, you didn’t pay income taxes on it back when you put it in the account; now it’s time to pay the piper.) You can begin withdrawing money from your traditional 401(k) without penalty when you turn age 59½. The rate at which your distributions are taxed will depend on what federal tax bracket you fall in at the time of your qualified withdrawal.
What are the Taxes on 401(k) Plan Distributions?
A withdrawal you make from a 401(k) after you retire is officially known as a distribution. While you’ve deferred taxes until now, these distributions are now taxed as regular income.
That means you will pay the regular income tax rates on your distributions. You pay taxes only on the money you withdraw. If you withdraw $10,000 from your 401(k) over the course of the year, you will only pay income taxes on that $10,000.
It’s possible to withdraw your entire account in one lump sum, though this will likely push you into a higher tax bracket for the year, so it’s smart to take distributions more gradually.
The good news is that you will only have to pay income tax. Those FICA taxes for social security and Medicare only apply during your working years. You will have already paid those when you contributed to a 401(k) so you don’t have to pay them when you withdraw money later. Indeed, now is about the time you’ll start to see the benefits of paying these taxes when you start using Social Security and Medicare.
State and local governments may also tax 401(k) distributions. As with the federal government, your distributions are regular income. The tax you pay depends on the income tax rates in your state.
If you live in one of the states with no income tax, then you won’t need to pay any income tax on your distributions. So depending on where you live, you may never have to pay state income taxes on your 401(k) money.
What are the Taxes on Employer Contributions?
In addition to your contributions, an employer may also put money into your 401(k). Once that money is in your account, the IRS treats it the same as your contributions.
You won’t pay any taxes while the money is in your account, but you will pay income taxes when you withdraw it. Unlike your own contributions, you don’t pay any payroll taxes when your employer contributes to your account. It’s truly free money. It doesn’t even count toward the $19,500 contribution limit for 2021.
What are the Deductions on the 401(k) Plan?
Your 401(k) contributions directly reduce your taxable income at the time you make them because they're typically made with pre-tax dollars. You'll pay taxes on less income as a result.
Your take-home pay won't be reduced by the full amount of your contributions. They're made before withholding is calculated, based on what remains after you've made them. These pre-tax contributions reduce your taxable income, and you pay less tax overall.
You'll often find that what you contribute costs less than you expect because of the income taxes you save. Your contributions to a 401(k) aren't taxed until you withdraw them in retirement. Your employer can contribute to your plan as well.
What are the Taxes on Different 401(k) Plans?
There are variations on the traditional 401(k). Some of these have different rules on taxation.
SIMPLE 401(k) plans and safe harbor 401(k) plans function mostly the same as far as employee taxes are concerned. They differ mostly in that employers have to make certain contributions. SIMPLE 401(k) plans also have a lower contribution limit.
The other type of 401(k) to note is a Roth 401(k). These work quite differently from traditional 401(k) plans. All contributions you make to a Roth 401(k) come from money that you have already paid payroll and income taxes on. Since you pay taxes before you contribute, you do not need to pay any taxes when you withdraw the money.
It’s beneficial to use a Roth 401(k) if you are in a low income tax bracket and expect that you will find yourself in a higher bracket later in your life. This is very similar to why you might want a Roth IRA.
What are the Taxes on Rolling Over a 401(k) Plan?
In the instance where you may want to transfer funds from an employer’s 401(k) into another account, the most common situation is would be when you leave an employer and want to transfer funds from your previous employer into your new employer’s 401(k). Or into your own individual retirement account (IRA).
Whenever you withdraw money from a 401(k), you have 60 days to put the money into another tax-deferred retirement plan. If you transfer the money within 60 days, you will not have to pay any taxes or penalties on your withdrawals.
You will need to say on your tax return that you made a transfer, but you won’t pay anything. If you don’t make the transfer within 60 days, the money you withdrew will add to your gross income and you will have to pay income tax on it. You will also pay any applicable penalties if you withdraw before age 59.5.
If you don’t want to worry about missing the 60-day deadline, you can make a direct 401(k) rollover. This means the money goes directly from one custodian (for instance, the 401(k) provider) to another (for instance, a brokerage handling your IRA) without ever being in your hands.
Finally, note that if you’re rolling over a 401(k) into a Roth IRA, you’ll need to pay the full income tax on the rolled-over amount. However, there’s no 10% penalty for doing this before age 59.5.
What are the Ways to Reduce 401(k) Taxes?
Don’t dip into your account if you can help it. Withdrawals, especially early ones, can trigger taxes.
Look for exceptions:
If you must make an early withdrawal from a 401(k), see if you qualify for an exception that will help you avoid paying an early withdrawal penalty.
See if you qualify for the saver’s credit on your contributions.
Borrow from your 401(k) instead of making an early withdrawal:
Not all 401(k) plans offer loans, though. Also, in most circumstances, you’ll need to repay the loan within five years and make regular payments. Check with your plan administrator for the rules.
Use tax-loss harvesting:
You might be able to offset the taxes on your 401(k) withdrawal by selling underperforming securities at a loss in some other regular investment account you might have. Those losses can offset some or all of the taxes on your 401(k) withdrawal.
See a tax professional:
There are other ways to minimize your 401(k) taxes, too, so find a qualified tax professional and discuss your options.
401k plans are vital to every employee as they seek out retirement options. In order to pay for life during retirement with a few luxuries along the way, you will need a steady source of income.
- A 401(K) plan is popularly known as an employer-sponsored retirement plan to which certain eligible employees based on pre-set criteria can make tax-deferred contributions from their salary or wages.
- One of the most powerful advantages of participating in a 401(k) is the money you save in taxes.
- As your 401(k) grows in value over time, you don’t pay taxes on those gains as you do with a bank account or individually owned stocks or mutual funds.
- Since you don’t pay taxes on any gains from the account, your 401(k) money can grow more quickly, year after year, than many other types of savings.
- Your 401(k) earnings accrue on a tax-deferred basis. That means the dividends and capital gains that accumulate inside your 401(k) are also not subject to tax until you begin withdrawals.
- Some employers offer to match the amount you contribute to your 401(k) plan.
- In a 401(k) plan you can continue to contribute to these for as long you're still working.
- 401(k)s offer excellent creditor protection.
- A 401(k) is a tax-deferred account. That means you do not pay income taxes when you contribute money
- The minimum age when you can withdraw money from a 401(k) is 59 ½.
- If you want to remove money from a 401(k) account without paying taxes, you will need to meet certain criteria.
- SIMPLE 401(k) plans and safe harbor 401(k) plans function mostly the same as far as employee taxes are concerned.
- The other type of 401(k) to note is a Roth 401(k). These work quite differently from traditional 401(k) plans.
- It’s beneficial to use a Roth 401(k) if you are in a low income tax bracket and expect that you will find yourself in a higher bracket later in your life.