Taxes on 401(k) Contributions
Contributions to a traditional tax-advantaged 401(k) plan are made with pre-tax income, which means that you won’t pay income tax on those contributions when they go into your 401(k). The amount of your contributions also reduces your adjusted gross income in the year you make them, potentially lowering your tax bill even further.
For example, if you earn $50,000 before taxes and contribute $2,000 to your 401(k), you’ll only be taxed on $48,000 when you file your tax return.
Note: The 2023 annual contribution limit to employer-sponsored retirement plans is $22,500 for individuals under 50 and $30,000 for those 50 and older (including a $7,500 catch-up contribution). Check out our article on 401(k) contribution limits for more information.
It’s important to note that the annual contribution limit applies to all of your 401(k) account contributions in total and that 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 early the following year 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 federal and state withholding tax you paid.
If you’re interested in a retirement plan that allows after-tax contributions, you might consider an Individual Retirement Account (or IRA). See our 401(k)s vs. IRAs article to learn more.
Taxes on 401(k) Withdrawals
After years of saving and contributing to your 401(k), it’s essential to understand the tax implications of withdrawing from it. Mistakes around withdrawing can be costly in a variety of ways.
Withdrawing before age 59½
If you choose to withdraw money from your 401(k) before the age of 59½, you may face both income taxes and early withdrawal penalties. If you’re able to keep the money inside your 401(k) until you retire, you’ll benefit from having avoided these extra fees and from decades of tax-deferred growth.
However, there are exceptions to the penalty rule, such as hardship distributions for medical bills or funeral expenses. The reality, however, is that the exceptions to the rule are likely not going to be normal course events for either you or your family, so it’s not best practice to rely on hardship withdrawal to cover ordinary things like ongoing medical expenses.
Hardship distributions should really be reserved for heavy and immediate financial needs.
Withdrawing at or after age 59½
Once you reach age 59½, you can withdraw money from your 401(k) without facing a penalty. The money you withdraw will be taxable as regular income in the year you take it since you didn’t pay income taxes on the contributions when you made them.
Once you hit your Required Beginning Date (currently age 73 as of 2023), you’ll need to take an annual Required Minimum Distribution based on the prior year’s ending account balance. RMDs will increase your AGI in the years you take them, and they can be costly if not properly planned for.
If you don’t take your RMD when you’re supposed to, the IRS can assess a penalty of 50% of the amount not distributed. As far as ordinary income tax goes, the rate at which your distributions are taxed will depend on your federal tax bracket at the time of your withdrawal.
Additionally, you can withdraw more than the minimum required amount if you choose to do so. But you’ll need to take out at least as much as the IRS requires; this is dependent on your age and your prior-year account balance.
If you’re interested in rolling over your 401(k) into an IRA — so you can eventually make penalty-free IRA withdrawals — speak with our Capitalize team today.
Calculate Withdrawals from Your 401(k)
To gain insight into your overall net withdrawal after tax deductions and any potential charges applied when you cash out your account, use a “Taxes On 401(k) Withdrawal Calculator.”
This tool will help you estimate your ordinary income, additional tax, income tax rate, and federal income tax due on your 401(k) withdrawals.
Traditional 401(k) vs. Roth 401(k)
Some key differences between a traditional 401(k) and Roth 401(k) exist around the tax treatment of contributions and withdrawals, as well as their respective withdrawal rules.
Roth 401(k) contributions, like Roth IRA contributions, are made with after-tax dollars, while traditional 401(k) contributions, like traditional IRA contributions, are made with pre-tax dollars.
As a result, Roth 401(k)s have tax-free withdrawals, while traditional 401(k)s require you to pay taxes on withdrawals.
Both types of accounts have their own unique benefits, so it’s crucial to consider your personal finance situation and future goals when choosing between them.
Interested in rolling a traditional 401(k) into a Roth 401(k) or another retirement savings account? Speak with a rollover specialist at Capitalize today.
Ways to Minimize 401(k) Taxes
There are various strategies to minimize your tax liability when withdrawing from your 401(k).
Perhaps the most powerful way to avoid significant taxes on your 401(k) withdrawals is to wait until age 59.5 before withdrawing any of the money. This helps you in a few ways. First off, you’ll avoid the 10% early withdrawal penalty. Next, you’ll keep the money growing tax-deferred. And finally, you’ll use the money for what it’s actually intended: retirement.
Another idea is to wait until you’re fully retired to begin making 401(k) withdrawals. Think about it: if you withdraw from your 401(k) plan while you’re still employed, those 401(k) withdrawals will be added to your taxable income for the year and potentially push you into a higher tax bracket. This is on top of the additional tax penalty for early distribution.
A third way to minimize 401(k)-related taxes is to consider your current tax bracket vs. what you think your tax rate will be when you retire. For example, if you think your current tax rate is lower than what you estimate it to be in retirement, then you should consider contributing to a Roth 401(k). If, on the other hand, you expect a lower tax rate in retirement, consider a traditional, pre-tax 401(k) instead.
Need Help Rolling Over Your 401(k) Retirement Plan?
In summary, retirees should be ready to pay some taxes when it comes time to start making withdrawals from their 401(k), but there are tried-and-true ways to minimize them.
Using a 401(k) calculator can help you better understand the taxes on 401(k) withdrawals and make informed decisions about your retirement savings. Additionally, consider working with your current plan administrator — or an independent financial advisor — if you’re not sure how to proceed.
At Capitalize, we specialize in finding and moving old retirement accounts, and we also provide various tools and information to assist you in your retirement journey.
Learn more about what Capitalize can do for you and 401(k) accounts today.
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