401(k) accounts provide employees with many tax benefits, but when you need the money, there are tax consequences you must understand.
The taxes you’ll owe depend on many factors, including the type of account, your age, whether you’re retired, and the reason for the withdrawal.
Basics of Taxes on 401(k) Accounts
You’ll pay taxes at some point on your 401(k) contributions and withdrawals; the question is when?
401(k) accounts are tax-deferred. This means you get the tax benefit now when you contribute, but you must catch up on the tax liability at some point, usually when you withdraw funds. But when you withdraw them will determine how much you pay in taxes.
In addition, if you have a Roth 401(k), you won’t defer taxes on your contributions. But you make your earnings potentially tax-free if you wait until retirement to cash them out.
The key to tax deferral is putting off the tax liability until you use the funds, usually in retirement. The goal is to be in a lower tax bracket at the time of withdrawal so you keep more of your contributions and pay less to Uncle Sam.
Of course, it doesn’t always work out as planned, so it helps to understand the different pre-retirement and post-retirement tax scenarios.
401(k) Tax Rates
Your 401(k) tax rates depend on when you withdraw funds (pre or post-retirement) and your current tax bracket. The more you withdraw, the higher the tax bracket will be. So it works to your benefit to time your withdrawals when your tax bracket is the lowest.
You only pay income taxes when you withdraw funds from your 401(k). FICA taxes are only paid during the years you work. However, if your state charges income tax, you’ll likely owe state taxes, too, but the amount varies by state.
Pre-Retirement Tax Scenarios
To help you understand how taxes on 401(k) accounts work, here are some common scenarios you may encounter.
1. Traditional 401(k) Contributions
Your traditional 401(k) contributions are pre-tax. In other words, you don’t pay taxes on the funds you earn if you put them in your tax-deferred 401(k). The funds remain tax-deferred as long as they are in your account. In addition, the earnings grow tax-deferred until you withdraw them.
2. Roth 401(k) Contributions
Roth 401(k) contributions work differently. Instead of deferring taxes on the contributions, you pay the taxes at the time you earn them. The earnings grow tax-free rather than tax-deferred, and if you wait until retirement, you don’t pay taxes on your withdrawals.
3. Employer Matching Contributions
Employer-match contributions are like free money! Don’t pass them up. When an employer matches all or a part of your contributions, you don’t pay income taxes on the earnings in the year they contribute. Since employers can only contribute to a traditional 401(k), you will pay income taxes only on the funds you withdraw, but not until you withdraw them.
4. Early Withdrawals and Penalties
Ideally, you should leave your 401(k) funds untouched until age 59 ½. That’s the magic age the IRS stops charging a penalty for early withdrawal. However, life happens, and sometimes you can’t help but withdraw funds early. If you must, you’ll pay a 10% penalty on the funds withdrawn early, plus income taxes at the federal and state level on any funds at your current tax rate.
5. Hardship Withdrawals
A hardship withdrawal is the one exception to the 10% early withdrawal penalty. The IRS has a strict list of rules outlining what qualifies as a hardship withdrawal, but some of the most common reasons include:
- Total and permanent disability
- Unreimbursed medical expenses exceeding 7.5% of your gross income
- Death of the participant
6. Maximum Contribution Limits
Each year, the IRS sets maximum 401(k) contribution limits to prevent employees from deferring too much of their salary.
However, the contribution limits are high enough to make it easy to get ahead for retirement. In 2023, the 401(k) contribution limits are $22,500 for employees, but you can have a combined total of $66,000 with employer contributions.
In addition, employees over 50 can contribute an additional $7,500 per year, pushing the combined limit to $73,500.
Total contributions may never exceed 100% of an employee’s income. And you may be subject to tax penalties if you contribute too much.
7. Beneficiaries
When setting up your 401(k), be sure to name beneficiaries. These people will receive your funds if you die before retirement or before using your funds.
You can choose a primary beneficiary or the main person to receive the funds and contingent beneficiaries. These named people would only receive the funds if the primary beneficiary didn’t receive the funds, primarily because they are no longer alive.
8. Rollovers
If you change jobs, moving your 401(k) funds is a good idea. While your ex-employer may let the funds sit, they will no longer match contributions. So leaving your funds where you may forget them doesn’t make sense.
The ideal situation is to roll over your funds directly into a new 401(k) or IRA. A direct rollover doesn’t risk incurring any taxes or penalties because the funds never touch your hands. Instead, they go from one tax-advantaged retirement account to another.
However, if your new employer doesn’t allow you to contribute to a 401(k) on day one, or you don’t have another job yet, you may withdraw the funds and figure out what to do with them after the fact.
The key is that you invest them in a tax-advantaged account within 60 days of withdrawal. If you wait, you’ll incur the early withdrawal 10% penalty and applicable income taxes.
Post-Retirement Tax Scenarios
Consider the following scenarios to understand how your retirement funds are taxed post-retirement.
1. Required Minimum Distributions (RMDs)
Required minimum distributions or RMDs are the required amount you must withdraw from your retirement account.
The IRS has the following age requirement:
“If you reach age 72 in 2022, you must take your first RMD by April 1, 2023, and the second RMD by Dec. 31, 2023. If you reach age 72 in 2023, your first RMD for 2024 (the year you reach 73) is due by April 1, 2025.”
The only exception is for workers with a 401(k) who are actively working; the RMDs don’t begin until they stop working.
The amount you must withdraw depends on your birth year and life expectancy. The IRS will notify you of the minimum amount you must withdraw by the stated date to avoid penalties for failure to take RMDs.
However, if you have withdrawn from your 401(k) long before reaching age 72 or 73, RMDs may not apply.
2. Roth 401(k) Withdrawals
Roth 401(k) withdrawals have different rules than traditional 401(k) rules. Unlike traditional 401(k) contributions, Roth 401(k) contributions aren’t taxed if you meet the following:
- Are at least 59 ½ years old before withdrawing
- The funds have been in the Roth 401(k) for at least five years
If you meet the above requirements, any distributions you take will not be added to your gross income or affect your tax liabilities.
Learn More: Roth vs Traditional IRAs
3. Managing Taxable Income
The key to keeping your tax rate as low as possible is strategically planning your retirement account withdrawals. This works best if you have multiple sources of income during retirement, some of which are tax-free.
A few strategies you may implement include:
- Use a Roth 401(k) or IRA to have some funds tax-free
- Delay withdrawals from taxable accounts during years you’re in a high tax bracket
- Take enough withdrawals that you can avoid RMDs
- Manage taxes from earned income (work) and taxable investments
4. Inherited 401(k) and Taxation
Considering the tax consequences is important if you inherit a 401(k) from a spouse or other relative. How much you pay in taxes depends on whether the 401(k) is from your spouse or someone else and how you receive it.
Inherited 401(K) From a Spouse
If you inherit a 401(k) from your spouse, you don’t pay an early withdrawal penalty but will owe taxes on any amount withdrawn. Here’s how it works
- Lump sum distribution – You pay taxes on the full amount, which may push you into a higher tax bracket, depending on your other income.
- Rollover into your existing 401(k) or IRA – You can roll the funds directly into your existing retirement account. The funds immediately become a part of the account, and all IRA or 401(k) rules apply, including early withdrawal penalties and RMDs.
- Rollover into an inherited IRA – If you inherited a 401(k) and IRA from your spouse, you can roll over the 401(k) into the IRA and take withdrawals before age 59 ½ without penalty.
- Leave the 401(k) as is – You also have the option to leave the 401(k) where it is, but standard rules will apply, including RMDs, when you reach age 73 if you haven’t yet.
Inherited 401(K) From a Non-Spouse
401(k)s inherited from non-spouses have slightly different rules, including the following:
- Rollover into inherited IRA – You have ten years to withdraw the funds and pay applicable taxes according to your tax break in that year.
- Leave the 401(k) as is – You also have the option to leave the 401(k) where it is; however, you have ten years to withdraw the funds and pay applicable taxes.
- Lump sum distribution – If you need the funds immediately, you can take a lump sum distribution, but know that the income may push you into a higher tax bracket, and you’ll owe taxes on the full amount.
5. Social Security and Medicare Taxes
Social Security and Medicare taxes are only applicable when you are actively working.
If you no longer work and only withdraw funds from your retirement accounts, pensions, or annuities, you only pay income taxes on the income (except Roth accounts) and not Social Security or Medicare tax.
6. Beneficiaries
How beneficiaries receive retirement account funds affects how much they owe in taxes. A large factor is their age.
Except for lump sum withdrawals upon inheritance, beneficiaries pay taxes at their current tax bracket when they withdraw funds.
How much they pay depends on whether the funds were from a spouse or non-spouse and if they are subject to Required Minimum Distributions because they reached 72 or 73 (depending on where your birthdate falls).
Claiming Taxable 401(k) Events When Filing
If you rollover, transfer, or withdraw funds from a 401(k), your retirement plan must send you IRS Form 1099-R.
This form tells you and the IRS how much money you withdrew from the account. It will also show if the administrator held taxes from the amount (usually 20%) so you can properly file your taxes and pay any applicable tax debt.
Tips for Reducing 401(k) Taxes
No one likes a hefty tax bill. Fortunately, there are ways to reduce your 401(k) taxes in addition to tax-efficient investing
Here are Some Quick Tips:
- Don’t make early withdrawals – You’ll pay a 10% penalty, plus increase the amount of income taxes you owe. Depending on how much you withdraw, you may also push yourself into a higher tax bracket and owe more taxes on all income.
- Use tax-loss harvesting – If you have underperforming assets, you may consider selling them during the year you withdraw from your 401(k). The loss on the underperforming assets will offset the taxes owed on your retirement withdrawal, reducing your liability.
- Try to make early withdrawals a hardship withdrawal – Work with your retirement plan administrator or tax professional to determine if you qualify for any hardship withdrawals if you must withdraw funds from your 401(k) early.
- Consider a 401(k) loan – If you’re withdrawing early, look at your 401(k) loan options. You usually have five years to repay the loan and will pay interest, but it’s to yourself, and you avoid the 10% early withdrawal penalty.
Finally, work with a tax professional to minimize your 401(k) taxes and maximize your earnings.
Conclusion
Understanding the tax liabilities on 401(k) accounts is important. Knowing what you might owe taxes or penalties and when you’ll be forced to take RMDs can help you plan accordingly.
The key is to minimize your tax liabilities while having enough money during retirement.
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