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401(k) and Taxes

A 401(k) can be an excellent tool to help you save for retirement, but it’s important to understand the potential tax consequences.

Written by Erin Gobler / July 11, 2022

Quick Bites

  • A 401(k) is a workplace retirement plan that allows employees to invest for retirement with the help of their employers.
  • A traditional 401(k) has pre-tax contributions, tax-deferred growth and withdrawals that are taxed as ordinary income.
  • A Roth 401(k) has after-tax contributions, tax-free growth and tax-free withdrawals during retirement.
  • 401(k) withdrawals before age 59½ could be subject to early withdrawal penalties, but there are some exceptions.

A 401(k) is a type of retirement plan, and they offer plenty of benefits and tax advantages. But as with any major financial product, it’s important to understand its tax implications.

In this article, we’ll break down how 401(k)s work, how contributions and withdrawals are taxed, distribution rules and some advantages and disadvantages of these accounts.

Inside this article

  1. What is a 401(k)?
  2. Taxes & your 401(k)
  3. Taxes on 401(k)
  4. 401(k) distribution rules
  5. Tax for 401(k) vs. an IRA
  6. 401(k) pros and cons
  7. FAQ

What is a 401(k)?

A 401(k) is an employer-sponsored retirement plan that allows workers to invest for retirement in a tax-advantaged way. These accounts are generally offered by for-profit companies and are named after the section of the IRS code where they’re regulated.[1]

Under the current rules, an employee can contribute up to $20,500 per year to their 401(k) plan. An additional catch-up contribution of $6,500 is allowed for workers 50 and older.[2]

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What Is a 401(k)?

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Employers can also contribute to their employees’ 401(k) accounts, which is part of what makes these plans so attractive for workers. Employer contributions are usually done as matching contributions, meaning they agree to match employees’ contributions up to a particular percentage of their salary. Employers can contribute regardless of whether the employee does.

The combined contribution limit for employee and employer contributions—but not including the catch-up contribution—is $61,000 in 2022.[3]

Once you’ve contributed to your 401(k), you can invest the funds to help them grow until your retirement. Each employer can choose its own menu of investment options to offer its employees. Most companies offer primarily mutual funds, but some may also offer company stock, individual securities and variable annuities.[4]

Taxes on 401(k) contributions and withdrawals

How your 401(k) contributions and withdrawals are taxed depends on whether they are traditional or Roth contributions.

Traditional 401(k)

Traditional 401(k) contributions are the most common type offered by most employers. When you make traditional 401(k) contributions, they are pre-tax. That means that (in most cases it works this way) employers withhold the money from your paycheck before taxes are applied, which reduces your taxable income—and, therefore, your tax burden—for the year.

Once the money is in your 401(k) it grows tax-deferred. You won’t be subject to income or capital gains taxes as long as the money remains in the account.

“Tax deferral is the key reason 401(k) plans are so popular,” says Gigi Verrey, vice president of wealth management at GCG Financial. “There are typically several investment options and the money grows income tax-deferred. You pay tax when you decide to withdraw the funds for retirement with some caveats.”

Once you reach retirement and withdraw money from your 401(k) plan, those distributions will be subject to income taxes.[1]

Roth 401(k)

The other type of 401(k) contribution that’s available is a Roth contribution. Not all employers offer these, but they’re becoming increasingly popular.

When you make a Roth contribution to your 401(k), you do so with after-tax money. These contributions don’t reduce your taxable income or tax liability for the year. However, once the money is in your 401(k), you’ll never pay taxes on it again. It grows-tax free in the account, and you can withdraw it tax-free during retirement.

“I typically suggest clients defer salary into both types of accounts to have more options for withdrawing money in retirement,” Verrey says.

Taxes on 401(k)

The amount of taxes you’ll pay on your 401(k) depends on your marginal tax rate and the amount you’re withdrawing. Tax rates in the U.S. range from 10% to 37%, so the rate you’ll pay on your withdrawals will fall somewhere between those. For example, if you withdraw $50,000 from your 401(k) and have an effective tax rate of 14%, you would pay roughly $7,000 on your withdrawal.

401(k) distribution rules

The money in your 401(k) is meant to be used for retirement. As a result, the Internal Revenue Service generally doesn’t allow distributions until you reach age 59½. Any funds withdrawn earlier could be subject to a 10% early withdrawal penalty in addition to any other income taxes you may owe.

What’s the 401(k) Early Withdrawal Penalty?

What’s the 401(k) Early Withdrawal Penalty?

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That being said, there are some exceptions that could allow you to withdraw from your 401(k). One of these exceptions is hardship distributions, which you can take if you have an immediate and heavy financial need. Expenses eligible for this distribution include:

  • Medical expenses

  • The purchase of a primary residence

  • Tuition, fees, and room & board

  • Payments to prevent an eviction

  • Funeral expenses

  • Costs related to the repair of a primary residents

It’s important to note that to qualify for the hardship distribution, you must have an immediate and heavy need and the 401(k) distribution must be necessary to satisfy that need. If you have other funds available to cover the expense, a hardship distribution may not be allowed.

There are a handful of other situations in which you can take an early distribution from your 401(k). Those situations include:

  • The death of the participant

  • A qualifying disability

  • A series of substantially equal periodic payments

  • After a separation of service at or after age 55

  • A court-ordered distribution after a divorce

  • Medical expenses up to the medical expense deduction

It’s important to note that even if you qualify for an exception that allows you to take a penalty-free early withdrawal from your 401(k), you’ll still be subject to income taxes.[5]

Tax treatment of a 401(k) vs. an IRA

An individual retirement account (IRA) is another of the most popular accounts available to help you save for retirement. The key difference is that, while a 401(k) is offered and managed by your employer, an IRA is fully managed by the individual using a brokerage account.

An IRA allows you to contribute up to $6,000 per year—or $7,000 if you’re 50 or older—or 100% of your earned income, whichever is lower.[6]

When it comes to the tax treatment of a 401(k) versus an IRA, they aren’t all that different. Both have traditional and Roth options, which allow you to make pre-tax or after-tax contributions. Pre-tax contributions require income taxes at the time of withdrawal, while Roth contributions don’t.

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“A Roth IRA contribution is limited to $6,000 and to $7,000 for those over 50 and there are limits to the amount one can contribute based on their adjusted gross income,” Verrey says. “A Roth 401K has a much higher deferral limit of $20,500 and employees over 50 can make an additional catch-up deferral of $6,500 with no adjusted gross income limits.”

Other than the contribution limits, the other major difference between a 401(k) and an IRA comes down to eligibility. To contribute to a 401(k), your employer must offer this type of account.

What Is an IRA?

What Is an IRA?

An IRA is one of the simplest ways to save for retirement. Unlike a 401(k), your employer doesn’t need to offer one—you can open one on your own.

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Anyone can contribute to a traditional IRA, but not everyone can deduct their contributions. If you have a retirement plan through your work—or your spouse does—you can only deduct your traditional IRA contributions if you have a modified AGI of $78,000 or less as a single filer or $129,000 or less as a married filer.[7]

The rules for a Roth IRA are even stricter since there are income limits that may prevent you from contributing to this type of account at all. Once you reach an income of $129,000 for single filers and $204,000 for married filers, the amount you can contribute to a Roth IRA will be reduced. And once your income reaches $144,000 as a single filer or $214,000 as a married filer, you won’t be able to contribute at all.[8]

401(k) advantages and disadvantages

Are you wondering whether a 401(k) plan is right for you? These plans have both advantages and disadvantages but are ultimately a great choice for most people.

401(k) advantages

“I truly only see the pros of a 401(k) plan,” Verrey says. “Immediate tax savings, deferred-tax growth, the availability to take loans against the balance in many plans, although unadvisable, all equal a win-win in my opinion.”

Some of the advantages of a 401(k) plan include:

  • Tax-advantaged contributions

  • Employer matching contributions

  • High contribution limits

  • Accessibly funds in a financial emergency

401(k) disadvantages

Despite their major advantages, 401(k) plans do have a few downsides to consider:

  • 10% penalty on most withdrawals before 59½

  • Potentially limited investment options

  • Plan fees that may be higher than other investment accounts

FAQ

Is a 401(k) pre-tax?

A 401(k) can be pre-tax if you choose to make traditional contributions. However, you can also make Roth contributions to many 401(k) accounts, which are done after tax.

How is a 401(k) taxed at withdrawal?

How your 401(k) is taxed at withdrawal depends on whether you made pre-tax or Roth contributions. If you made pre-tax contributions, your withdrawals will be taxed as ordinary income. If you made Roth contributions, you won’t pay any taxes on your withdrawals.

How do I avoid taxes on my 401(k) withdrawals?

The best way to avoid paying taxes on your 401(k) withdrawals is to make Roth contributions to your account instead of pre-tax ones. With Roth contributions, you’ll pay income taxes on the money you contribute to the account but then won’t pay taxes while the money grows in the account or at the time of withdrawal.

Article Sources
  1. “401(k) Plan Overview.” IRS. https://www.irs.gov/retirement-plans/plan-participant-employee/401k-resource-guide-plan-participants-401k-plan-overview.
  2. Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits.” IRS. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits.
  3. “401(k) Plans - Deferrals and matching when compensation exceeds the annual limit.” IRS. https://www.irs.gov/retirement-plans/401k-plans-deferrals-and-matching-when-compensation-exceeds-the-annual-limit.
  4. “Investing in Your 401(k).” FINRA. https://www.finra.org/investors/learn-to-invest/types-investments/retirement/401k-investing/investing-your-401k.
  5. “401(k) Resource Guide - Plan Participants - General Distribution Rules.” IRS. https://www.irs.gov/retirement-plans/plan-participant-employee/401k-resource-guide-plan-participants-general-distribution-rules.
  6. “Retirement Topics - IRA Contribution Limits.” IRS. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits.
  7. “2022 IRA Contribution and Deduction Limits Effect of Modified AGI on Deductible Contributions If You ARE Covered by a Retirement Plan at Work.” IRS. https://www.irs.gov/retirement-plans/plan-participant-employee/2022-ira-contribution-and-deduction-limits-effect-of-modified-agi-on-deductible-contributions-if-you-are-covered-by-a-retirement-plan-at-work.
  8. “Amount of Roth IRA Contributions That You Can Make for 2022.” IRS. https://www.irs.gov/retirement-plans/plan-participant-employee/amount-of-roth-ira-contributions-that-you-can-make-for-2022.

About the Author

Erin Gobler

Erin Gobler

Erin is a personal finance expert and journalist who has been writing online for nearly a decade. Erin’s work has appeared in major financial publications, including Fox Business, Time, Credit Karma, and more.

Full bio

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