401(k) Tax

Retirement accounts like 401(k)s and others are often referred to as tax-advantaged accounts due to the tax benefits that they provide. Unfortunately, that doesn’t mean that you’ll never pay tax when saving for retirement with a 401(k). 

Below, we take a closer look at the tax benefits a 401(k) provides and how, exactly, your 401(k) will be taxed.

What is a 401(k)?

A 401(k) is a specific type of investment account that allows individuals to save and invest for retirement while enjoying certain tax benefits (discussed below). Importantly, 401(k)s are sponsored by your employer, making them an employer-sponsored retirement account as opposed to an individual retirement account (IRA).

Some important things to note about saving in a 401(k):

• Your employer may offer a match, helping you boost your retirement savings. Employer contributions sometimes vest over time. That means if you leave the company before a certain amount of time has elapsed, you may not be able to keep the money your employer contributed.
• Your contributions are automatically deducted from your paycheck, making it an automatic form of saving.
• You can contribute up to $20,500 to your 401(k) in 2022 if you are younger than 50, or up to $27,000 if you are 50 or older.
• You can contribute to an IRA on top of your 401(k).
• There are two main varieties of 401(k)s — traditional and Roth, each of which is taxed differently. This article focuses mainly on traditional 401(k)s, though we do also answer questions about Roth tax treatment below.

How are 401(k)s taxed?

Saving in a 401(k) can impact your taxes in several ways, depending on whether you are contributing to an account during your working years, withdrawing from an account during retirement, or accessing your funds early. 

1. How 401(k) taxes work for contributions

A traditional 401(k) is known as a tax-deferred account. This means that you do not pay income taxes on any contributions you make to your 401(k) during the year in which you make them. Unlike a taxable investment account, you won’t owe any tax as your investments grow. Instead, you pay income taxes on any withdrawals (called distributions) you make during retirement (more on this below). In this way, contributing to a 401(k) reduces your current tax burden.

For example, imagine that you are a single filer earning $75,000 in 2022 and contributing $15,000 to a traditional 401(k) account. When you file your taxes for this year, you won’t owe any tax on the $15,000 you contributed. At a 22 percent tax rate, that’s a savings of $3,300 in tax — money that you can use for something else now. 

2. How 401(k) taxes work for withdrawals in retirement

When you begin withdrawing from your traditional 401(k) in retirement, you will owe income taxes on your withdrawals. Importantly, you will be taxed based on your current income tax bracket, which may be lower than during your peak earning years. 

You can begin withdrawing from your 401(k) penalty-free starting at age 59½, but you must take a required minimum distribution (RMD) from your 401(k) starting in the year that you turn 72.  The current required beginning date for most people (it’s different if you have more than a 5 percent ownership stake in the company your 401(k) is through) is April 1 of the year following the year in which the 401(k) plan participant reaches age 72. This was previously age 70 1/2 for those born on or before June 30, 1949. If you fail to take your RMD, you may pay a 50 percent excise tax on the amount not distributed.

3. How 401(k) taxes and penalties work for early withdrawals

If you withdraw from your 401(k) before you reach 59½, you’ll owe income taxes that year on the amount you withdraw. Exactly how much you owe will depend on your tax bracket. 

Additionally, you will be required to pay a 10 percent penalty on top of the income tax.

There are certain exceptions that may allow you to make a withdrawal penalty- free — such as buying a first home or paying for certain medical expenses. That said, most financial advisors would recommend that you do not make an early withdrawal and instead allow your money to continue growing for retirement.   

4. Taxes on a Roth 401(k)

Taxes work differently for Roth 401(k)s. 

If you contribute to a Roth 401(k), you will pay income taxes on your contributions in the year you make the contribution — but you will pay no tax as your money grows and generally no income tax when you take withdrawals during retirement. Roth 401(k)s are subject to RMDs, but you can avoid this by converting the money in your Roth 401(k) into a Roth IRA.

Ways to minimize your 401(k) tax burden

There is no way to avoid paying the taxes you owe on accounts like a 401(k) or Roth 401(k). However, when you’re strategic about your contributions and withdrawals, there are ways to minimize the amount you owe in tax on your 401(k).

Managing your 401(k) and overall tax burden

The key to managing your tax burden as you save for retirement and when you’re making withdrawals in retirement is to diversify the location of your assets. This gives you more flexibility.

For instance, when you’re saving for retirement, let’s say one year your earnings spike because you got a big commission or bonus. That year you may want to stop contributing to any Roth accounts and instead contribute to traditional accounts. This helps reduce potentially higher taxes in that year. On the flip side, if you have a year with lower income, you may want to up your Roth contributions.

Then in retirement you can take withdrawals from both accounts, using them strategically. For instance, you might take withdrawals from your traditional account up to the point where you would cross into a higher tax bracket, then take withdrawals from your Roth account after that.

By taking withdrawals strategically, you manage your taxes in a way that minimizes how much you will pay overall. The good news is that you don’t have to figure all that out on your own. A financial planner can help you understand how taxes will impact your retirement and minimize your tax burden through an optimized withdrawal strategy that includes a range of financial options beyond just your 401(k) and Roth accounts.

All investments carry some level of risk including the potential loss of all money invested.  No investment strategy can guarantee a profit or protect against a loss. This publication is not intended as legal or tax advice.  Financial Representatives do not render tax advice.  Consult with a tax professional for tax advice that is specific to your situation.