What to Know About 401(k) Taxes

While investing in a traditional 401(k) plan can prove advantageous for your future retirement, it’s also necessary to be aware of the tax obligations that accompany your traditional 401(k) plan. Read on to learn more about 401(k) taxes and potential withdrawal penalties.

How are 401(k) contributions taxed?

When making contributions to your traditional 401(k) plan, the funds are taken from your gross paycheck before the IRS takes its percentage. This is also known as pre-tax income. Due to your contributions coming from your pre-taxed wages, you may take home more money because you’ll be taxed on a smaller amount.

Individuals under the age of 50 can contribute up to $22,500. Those aged 50 and older may contribute up to $30,000. With a traditional 401(k) plan, FICA tax contributions such as Medicare and Social Security must still be made.

In January, you’ll receive a W-2 form from your employer detailing your tax withholdings and 401(k) contributions.

How are 401(k) early withdrawals taxed?

Generally, you don’t have to pay taxes on your traditional 401(k) until you withdraw the funds. Though withdrawal taxes are inevitable with a traditional 401(k) plan, you stand to face more financial consequences with early withdrawal.

When you withdraw your traditional 401(k) funds, the IRS requires 20% tax withholding on those funds, which means though you withdraw a certain amount, you will only receive a fraction of it.

The IRS will also penalize you for withdrawing your funds before retirement by assessing a 10% penalty when filing your tax return, resulting in paying an additional amount on top of the 20% tax you had withheld.

Are there exceptions to the early withdrawal tax penalty?

Ideally, you want to withdraw your 401(k) funds during retirement. However, in the case of emergencies, you may need to access these funds earlier. If you do need access to your traditional 401(k) funds before age 59 1/2, there are a few instances in which you would not be required to pay the 10% penalty. Some of these exceptions include but are not limited to:

• Leaving your job after the age of 55
• Payment under a Qualified Domestic Relations Order
• Qualified birth or adoption distributions
• Emergency personal expense distributions
• Distributions to individuals who are domestic abuse victims
• Distributions made to terminally ill individuals
• Disability or death
• Unreimbursed medical expenses
• Qualified reservist distributions

How are 401(k) retirement withdrawals taxed?

Once you reach the age of 59 ½, you can begin withdrawing from your traditional 401(k) without facing a penalty. However, you will need to pay taxes on it like regular income since it was not taxed when you made your initial contributions. The percentage you will have to pay will depend on which tax bracket you’re in. There are a few points worth noting when withdrawing your 401(k) funds after retirement.

• You must withdraw a minimum distribution once you reach the age of 73
• Failing to withdraw your minimum distribution can result in a penalty
• You are permitted to withdraw more than the minimum amount.

How are Roth 401(k) plans taxed?

The benefit of a Roth 401(k) plan is that the contributions are made from taxed income. This means that because you’re contributing from taxed income, you won’t have to pay taxes on it later. Employees with Roth 401(k) plans will not have to worry about withdrawal taxes or penalty if their first contribution was at least five years ago and they have reached the age of 59 ½.

Whether you decide on a traditional 401(k) or a Roth 401(k), knowing your tax responsibilities can help make your decision a smart and easy one. For more information on how 401(k)s work and choosing the best plan for your retirement, don’t hesitate to visit our Help Center or reach out to our knowledgeable team at sales@eplanservices.com today.

This content is for educational purposes only, is not intended to provide specific legal advice, and should not be used as a substitute for the legal advice of a qualified attorney or other professional. The information may not reflect the most current legal developments, may be changed without notice and is not guaranteed to be complete, correct, or up to date.