For most 401(k) plans, the 401(k) tax only applies to withdrawals. Most 401(k) plans are tax-deferred, meaning no income tax on contributions or earnings, interest, or dividends that the money produces until the owner withdraws them.
This makes 401(k) not just a way to save for retirement; it's also a great way to lower your tax bill. But there are 401(k) tax rules you should be aware of, as well as some strategies that can make your tax bill even lower. Here's a summary of how 401(k) taxes work and everything in between.
401(k) contribution tax
Contributions to a traditional 401(k) plan come from your paycheck before the IRS receives your contributions, so if you earn $1,000 before labor tax and contribute $200 to 401(k), that $200 less is what you will be taxed upon when you file your income tax return, you'd report $800 instead of $1,000.
If an employer offers a Roth 401(k), that means you are contributing money after-tax, rather than before tax, as with traditional 401(k).
In the 2020 and 2021 fiscal year, you can contribute up to $19,500 per year to a 401(k) plan. If you are 50 and above, you can contribute $26,000.
The yearly contribution limit is per individual and applies to all contributions to your 401(k) account in total.
You still have to pay Social Security and Medicare taxes for 401(k) employee contributions.
Your employer will provide you with a W-2 in January, showing how much they paid you in the preceding tax year, as well as how much you contributed to 401(k) and how much you paid withholding tax.
401(k) withdrawal: How much do I have to pay?
Contributions and investment growth in a traditional 401(k) plan are deferred, which means you don't pay cash taxes until you withdraw from your account.
If you own a Roth 401(k), in most cases, you will not be obliged to pay taxes at the time of withdrawal, as you will have already paid the taxes in advance.
401(k) taxes if you withdraw money when you retire
For traditional 401(k) plans, the money withdrawn is taxed as regular income, like income from a job, in the year you make the distribution. For Roth 401(k), the money withdrawn is not taxable (you already paid income tax when you put the money into your account). You are qualified to withdraw money from your traditional 401(k) plan without penalty when you are 59½ years old.
You can start withdrawing money from Roth 401(k) without penalty after maintaining your account for at least five years and being at least 59½ years old.
If you have retired, you should start receiving the required minimum distributions (RMD) from your account when you are 72 years old.
If you neglect to make the required minimum distribution (RMD) when you should, the IRS may impose a fine of 50% of the undistributed amount.
You can withdraw more than the minimum from your account.
401(k) taxes if you withdraw the money in advance
For traditional 401(k) plans, there are three main consequences of retiring early or retiring before age 59½:
Taxes will be withheld: The IRS typically requires an automatic 20% withholding tax of a 401(k) prepayment for taxes. So if you take out $10,000 from 401(k) at age 40, you can only get around $8,000.
The IRS will penalize you: If you withdraw 401(k) money before the age of 59½, the IRS typically imposes a 10% penalty when filing your tax return. That could mean giving the government $1,000 more on that $10,000 withdrawal.
Less money: After that, you may have less money, especially if the market is down when you retire. This can have long-term consequences.
There are many exceptions. But you can avoid the 10% IRS penalty for early withdrawals from a traditional 401(k) if:
Died.
Over contributed to your 401(k).
Put the money in another retirement account.
Qualify for hardship distribution with the plan administrator.
Receive the payout over time.
The birth of a child
The adoption of a child.
Use the money to pay an IRS tax.
Use the money to pay some medical bills.
You are getting divorced.
You are or become disabled.
You have been the victim of a disaster.
You quit your job and reached a certain age.
You were in the military.
You can withdraw money from Roth 401(k) earlier if you have maintained your account for a minimum of five years and need the money due to disability or death.
Ways to lower your 401(k) taxes.
Wait as long as possible to withdraw money from your account. Withdrawals trigger taxes.
If you need to make an early withdrawal from a 401(k), check if you qualify for an exemption that will help you avoid paying an early withdrawal fine.
Check if you are eligible for savings credit on your contributions.
Be careful when rolling over your account. Rollover from a 401(k) account to another 401(k), or IRA account will generally not generate a fine if you deposit your money into the new account within 60 days. Otherwise, the IRS could view the change as a distribution, generating taxes and possibly even a penalty.
Borrow from your 401(k) rather than making an early withdrawal. However, not all 401(k) plans offer loans. Also, in most cases, you will need to repay the loan within five years and make regular payments.
Use the tax-loss harvesting. You can offset the taxes on your 401(k) withdrawal by selling non-performing bonds at a loss to any other regular investment account you have. These losses may offset some or all of the 401(k) withdrawal taxes.
Consult a tax expert. There are other ways to reduce taxes to a minimum of 401(k), so find a qualified tax professional and consider your options.
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