Investing in a 401(k) retirement savings plan can amplify future savings, especially if certain workplace benefits—such as an employer contribution match—are offered. However, there are tax implications with these retirement accounts, and investors will want to know when they can expect to pay the piper on those savings and any recognized growth.
Different types of 401(k)s offer different advantages, such as tax-deferred contributions or tax-free growth. Here’s a look at the rules governing how 401(k) contributions are taxed.
Do you have to pay taxes on 401(k) contributions?
Whether an individual pays taxes at the time of contribution or at distribution, the government is going to want their cut of those retirement savings. With a traditional 401(k) account, taxes are imposed at the time of distribution, or when savings are withdrawn at retirement.
A traditional 401(k) plan is considered a tax-deferred account. This means that contributions an employee makes to a traditional 401(k) can be deducted from their taxable income in the year they are earned. Those savings can then be invested in various funds and will ideally continue to grow over the years until the employee reaches retirement age. No taxes are owed on the funds until they are withdrawn in retirement.
However, once the retiree reaches age 59½ (or older) and begins making 401(k) withdrawals, any distributions taken are included in the retiree’s taxable income for the year. The rate at which these distributions are taxed depends on factors like the retiree’s total income and any deductions for which they qualify.
Traditional vs. Roth 401(k)
Traditional 401(k)s and Roth 401(k)s work differently in regards to taxes. Some employers may offer one type of plan, while others allow employees to choose either retirement account option.
Neither a traditional 401(k) nor a Roth 401(k) imposes income limits on participants. Each allows an employee to contribute up to $20,500 per year for 2022, or up to $27,000 if they are 50 or older. Both have a minimum 401(k) distribution age of 59½, and both require account holders to begin taking required minimum distributions starting at age 72.
The biggest difference between the two accounts is how they are taxed.
Whereas a traditional 401(k) is funded with pre-tax contributions, a Roth 401(k) works the opposite way. Roth 401(k)s are funded with after-tax dollars. Contributions are not tax-deductible, and there is no tax advantage in the year that these contributions are made.
Instead, savings are invested and any growth is tax-free. When the employee reaches retirement (age 59½ or older), has held the account for at least five years, and elects to take qualified distributions, both the original savings and any growth in the account can be withdrawn tax-free.
Side note: Try Titan’s free 401(k) Calculator to project how much your 401(k) will give you in retirement.
401(k) taxes for early withdrawals
As long as an employee is at least 59½ years old, they can take distributions from a 401(k) retirement account without penalty. If 401(k) withdrawals are taken before then, early withdrawal penalties may be imposed in the form of additional taxes.
The additional tax for taking an early withdrawal from a tax-advantaged retirement account is 10%, on top of any applicable income taxes due. Still, there are certain exceptions to this penalty. The 10% early withdrawal tax may be waived if the account owner is withdrawing 401(k) funds in order to pay for certain expenses, called hardships. These include:
- The birth or adoption of a child
- Expenses related to total and permanent disability
- Qualified reservists called to active duty
- Unreimbursed medical expenses
Hardships are not considered loans, but early distributions. The funds cannot be more than the actual amount necessary to satisfy the immediate and heavy need that the hardship presents. These funds also cannot be repaid back to the 401(k) account.
Some 401(k) plans allow employees to take loans against their account, but these loans are contingent upon the plan’s rules and usually only available while the account holder is an active employee for their company. If an account owner takes out a loan against their 401(k) savings and fails to repay that loan within five years, this can also trigger early withdrawal penalties and taxes.
The bottom line
Many employees use 401(k) plans to save for retirement, however, there will be taxes on those retirement savings. Employees will either pay taxes on their 401(k) at the time of contribution, as with a Roth 401(k) plan, or when they take qualified distributions in retirement, as with a traditional 401(k) plan. For future retirees, deciding between them means considering factors such as the owner’s current tax bracket and their projected future income.