401(k) accounts provide employees with many tax advantages, but when you need the money, there are tax consequences you must understand.
The taxes you owe depend on several factors, including the type of account, your age, whether you are retired, and the reason for the withdrawal.
Tax basics 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 advantage now when you contribute, but you must catch up on the tax liability at some point, usually when you withdraw the money. But when you withdraw it, it will determine the amount you pay in taxes.
Additionally, if you have a Roth 401(k), you won’t defer taxes on your contributions. But you make your earnings tax-free if you wait until retirement to cash them out.
The key to tax deferral is to postpone the tax liability until you use the money, usually in retirement. The goal is to be in a lower tax bracket at the time of withdrawal so you can keep more of your contributions and pay Uncle Sam less.
Of course, it doesn’t always work out as planned, so it’s helpful to understand the different pre-retirement and post-retirement tax scenarios.
401(k) Tax Rates
401(k) tax rates depend on when you withdraw the money (before or after retirement) and your current tax bracket. The more you withdraw, the higher your tax bracket will be. Therefore, it is beneficial for you to time your withdrawals when your tax bracket is lowest.
You only pay income taxes when you withdraw money from your 401(k). FICA taxes are only paid during the years you work. However, if your state imposes an income tax, you will likely owe state taxes as well, but the amount varies by state.
Pre-retirement tax scenarios
To help you understand how taxes work on 401(k) accounts, 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 money you earn if you put it in a tax-deferred 401(k). The money remains tax-deferred as long as it is in your account. Additionally, earnings grow tax deferred until you withdraw them.
2. Roth 401(k) contributions
Roth 401(k) contributions work differently. Instead of deferring taxes on contributions, you pay taxes as you earn. Earnings grow tax-free rather than tax-deferred, and if you wait until retirement, you don’t pay taxes on your withdrawals.
3. Matching employer contributions
Employer contributions are like free money! Don’t miss them. When your employer matches all or 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’ll only pay income taxes on the money you withdraw, but not until you withdraw it.
4. Early withdrawals and penalties
Ideally, you should leave your 401(k) funds untouched until age 59 ½. This is the magical age when the IRS stops charging a penalty for early withdrawal. However, life happens, and sometimes you can’t help but withdraw money early. If you must, you’ll pay a 10% penalty on funds withdrawn early, plus federal and state income taxes on any funds at the current tax rate.
5. Hardship Withdrawals
Hard withdrawal is the only exception to the 10% early withdrawal penalty. The IRS has Strict list of rules Determining what constitutes withdrawal is difficult, but some of the more common reasons include:
- Total and permanent disability
- Unpaid medical expenses that exceed 7.5% of your gross income
- Death of participant
6. Maximum contribution limits
Each year, the IRS sets 401(k) contribution caps to prevent employees from deferring too much of their paychecks.
However, the contribution limits are high enough to make it easier to move forward into retirement. In 2023, 401(k) contribution limits are $22,500 for employees, but you can have a grand total of $66,000 with employer contributions.
Additionally, employees over the age of 50 can contribute an additional $7,500 annually, bringing the total limit to $73,500.
Total contributions may not exceed 100% of the employee’s income. You may be subject to tax penalties if you contribute too much.
7. Beneficiaries
When setting up a 401(k), be sure to name the beneficiaries. These people will get your money if you die before retirement or before your money is used.
You can choose the primary beneficiary or main person to receive funds and potential beneficiaries. These named people will only receive the money if the primary beneficiary does not receive the money, primarily because they are no longer alive.
8. Coups
If you change jobs, moving your 401(k) funds is a good idea. While your former employer may allow the funds to remain, they will no longer match contributions. So leaving your money where you might forget it makes no sense.
The ideal situation is to roll your money directly into a new 401(k) or IRA. A direct rollover does not risk incurring any taxes or penalties because the funds never touch your hands. Instead, they move from one tax-advantaged retirement account to another.
However, if your new employer doesn’t let you contribute to your 401(k) on day one, or you don’t have another job yet, you can withdraw the money and figure out what to do with it after the fact.
The key is to invest it in a tax-advantaged account within 60 days of withdrawal. If you wait, you will incur a 10% early withdrawal penalty and applicable income taxes.
Post-retirement tax scenarios
Consider the following scenarios to understand how your retirement funds will be taxed after 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 requirements:
“If you turn 72 in 2022, you must take your first RMD by April 1, 2023, and your second by December 31, 2023. If you turn 72 in 2023, your first RMD for 2024 (the year you turn 73 ) is due by April 1, 2025.
The only exception is for workers with a 401(k) who are actively employed; RMDs don’t kick in until you 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 specified date to avoid penalties for failing to take RMDs.
However, if you withdraw from your 401(k) plan well before age 72 or 73, RMDs may not apply.
2. Roth 401(k) Withdrawals
Roth 401(k) withdrawals have different rules than traditional 401(k)s. Unlike traditional 401(k) contributions, Roth 401(k) contributions are not taxable if you meet the following:
- You must be at least 59 and a half years old before withdrawal
- The money has been in the Roth 401(k) for at least five years
If you meet the above requirements, any distributions you make will not add to your gross income or affect your tax liability.
Learn more: Roth vs. Traditional IRAs
3. Managing taxable income
The key to keeping your tax rate as low as possible is to strategically plan your retirement account withdrawals. This works best if you have multiple sources of income during retirement, some of which are tax-deductible.
Some strategies you can implement include:
- Use a Roth 401(k) or IRA to get some tax-free money
- Delay withdrawals from taxable accounts during years when you are in a high tax bracket
- Make enough withdrawals so you can avoid RMDs
- Tax management of earned income (work) and taxable investments
4. I inherited a 401(k) and taxes
It’s important to consider the tax consequences if you inherit a 401(k) from a spouse or other relative. The amount you pay in taxes depends on whether the 401(k) is from your spouse or someone else and how you receive it.
I inherited a 401(k) from my husband
If you inherit a 401(k) from your spouse, you won’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 entire amount, which could push you into a higher tax bracket, depending on your other income.
- Roll over to your current 401(k) or IRA – You can transfer funds directly to your existing retirement account. The funds immediately become part of the account, and all IRA or 401(k) rules apply, including early withdrawal penalties and RMDs.
- Roll over to an inherited IRA -If you inherit a 401(k) and an IRA from your spouse, you can roll over the 401(k) to an IRA and make withdrawals before age 59 ½ without penalty.
- Leave your 401(k) as is -You also have the option of leaving your 401(k) as is, but standard rules, including RMDs, will apply when you reach age 73 if you haven’t done so yet.
I inherited a 401(k) from someone other than my spouse
401(k)s inherited from non-spouses have slightly different rules, including the following:
- Rollover to an inherited IRA – You have ten years to withdraw the funds and pay applicable taxes based on your tax credit for that year.
- Leave your 401(k) as is -You also have the option of leaving your 401(k) where it is; However, you have ten years to withdraw the funds and pay the applicable taxes.
- Lump sum distribution -If you need the money right away, you can take a lump sum distribution, but be aware that the income could 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 only apply when you’re actively working.
If you are no longer working and only withdraw money from retirement accounts, pensions, or annuities, you only pay income taxes on the income (except for Roth accounts) and not Social Security or Medicare tax.
6. Beneficiaries
How your beneficiaries receive retirement account funds affects how much taxes they owe. A big factor is their age.
Except for lump sum withdrawals upon inheritance, beneficiaries pay taxes in their current tax bracket when they withdraw the funds.
The amount they pay depends on whether the money is from a spouse or a non-spouse and whether they are subject to required minimum distributions because they reached 72 or 73 (depending on where your birthday falls).
Claim 401(k) taxable events when you file
If you roll over, transfer, or withdraw money from your 401(k), your retirement plan must send it to you IRS Form 1099-R.
This form and the IRS tell you how much money you have withdrawn from the account. It will also show whether the administrator is withholding taxes from the amount (usually 20%) so you can file your taxes correctly and pay any applicable tax debt.
Tips for reducing 401(k) taxes.
Nobody likes a huge tax bill. Fortunately, there are ways to reduce 401(k) taxes in addition to tax-efficient investing
Here are some quick tips:
- Do not withdraw early – You will pay a 10% fine, in addition to an increase in the amount of income taxes you owe. Depending on the amount 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 might consider selling them during the year you withdraw from your 401(k). The loss of underperforming assets will offset the taxes due on your retirement withdrawal, reducing your liability.
- Try to make early withdrawals a difficult withdrawal -Work with your retirement plan administrator or tax professional to determine if you qualify for any hard withdrawals if you must withdraw money from your 401(k) early.
- Consider a 401(k) loan. -If you’re withdrawing early, check out your 401(k) loan options. You usually have five years to repay the loan and you will pay the interest, but this is for yourself, so you avoid the 10% early withdrawal penalty.
Finally, work with a tax professional to minimize your 401(k) taxes and maximize your earnings.
conclusion
It’s important to understand the tax liabilities on 401(k) accounts. Knowing what you might owe in taxes or penalties and when you’ll have to take an RMD can help you plan accordingly.
The key is to minimize your tax liabilities while having enough money during retirement.