401(k) Plans – How Contributions and Withdrawals Are Taxed

In 2022, 40% of Americans said they were afraid they could never afford to retire

Although many of us aren’t saving enough for retirement, a 401(k) plan can be a huge help. This type of savings plan is provided by some employers, and it promotes retirement savings by allowing you to put a portion of your wages directly into a retirement savings account.

On top of that, you may be able to get a free match on your contribution from certain employers, and putting money into a 401(k) can also help you reduce your tax bill.

Are 401(k) Contributions Tax Deductible?

Contributions to your 401(k) are not tax deductible, but they do help lower your tax bill.

That’s because the money that goes from your paycheck into your 401(k) is considered “pre-tax,” meaning you don’t have to pay income taxes on it until you make a withdrawal. So, by making direct contributions to your 401(k), you reduce the amount of taxes that are withheld from your paycheck.

There is, however, a limit to the 401(k) tax benefit, since the maximum annual amount you can contribute is $22,500 (as of 2023) or $30,000 for people over 50 years old.

How Are 401(k) Withdrawals taxed?

Contributing to a 401(k) helps set you up for a financially stable future, but taking money out before you retire can undo your hard work.

Any time you make a 401(k) withdrawal you’ll have to pay income tax on the amount you take out, but pulling money out before retirement could also mean facing hefty fees, plus losing out on some of the interest you would have otherwise earned on your savings.

Early 401(k) Withdrawal Tax

If you’re facing a financial emergency, you might be tempted to pull money out of your 401(k). But you should always consider other options, since making an early withdrawal – before the age of 59.5 – can be one of the most expensive ways to access cash.

These are the penalties you could pay for an early 401(k) withdrawal:

• You’ll owe income taxes on the amount you withdraw (often at a higher tax rate than when you’re retired)
• 20%  withholding from the IRS
• 10% early withdrawal penalty from the IRS

To give you an idea of the cost, someone earning between $45,000 and $95,000 a year who makes an early withdrawal of $10,000 could owe $5,200 in IRS penalties and income taxes.

There are, however, some withdrawal reasons that may be exempt from the 10% IRS penalty, including transferring of the money into another retirement account, total and permanent disability or qualified higher education or medical expenses.

Retirement 401(k) Withdrawal Tax

Once you reach retirement age, you can draw money from your 401(k) without IRS penalties. But you’ll still have to pay income taxes on the amount that’s distributed if you didn’t pay them when you made the deposit.

Your 401(k) taxes will be based on your income when you take the distribution. For example, if your income (including 401(k) distribution) is in the 24% tax bracket when you retire, your distribution will be taxed at 24%.

For most people, paying income taxes at the time of withdrawal instead of at the time of deposit saves them money, since their tax bracket is typically lower in retirement. On the other hand, the distributions can bump you into a higher tax bracket, which would increase your tax bill, your Social Security benefit taxes, and the cost of your Medicare B premiums.

How Are Different 401(k) Plans Taxed?

There are several different types of retirement plans, including different 401(k)s. It’s important to understand the differences between them since they can impact your taxes and retirement income, but the key difference is whether you’ll pay income taxes now or later.

Roth 401(k) vs Traditional 401(k) Taxes and Rules

Roth 401(k)s are relatively new—they first became available in 2006. Here’s a quick reference guide for your questions about how they compare to the traditional 401(k) that’s been around since 1986.

Is It Better to Contribute to a 401(k) Pre or Post Tax?

The decision to make a pre- or post-tax contribution to your 401(k) depends on your situation. If you believe you’ll be earning more money when you retire, it can be beneficial to choose an after-tax account like a Roth 401(k), where you pay your taxes up-front, based on your current income.

If you expect your income to drop during retirement, like it does for most people, then you can save money by choosing a pre-tax account like a traditional 401(k), and paying taxes based on your income during retirement.

How to Reduce Taxes on Your 401(k) Account

The amount of taxes you pay on your 401(k) can increase if you take certain actions. If you want to avoid extra 401(k) taxes, here are some things to do:

• Don’t withdraw funds early: Wait until after you’re 59.5 years old to take your retirement distributions.
• Don’t use 401(k) loans: Consider personal loans or other financing options that are cheaper than 401(k) loans.
• Keep an emergency fund: Resist the temptation to make an expensive, early draw by keeping cash accessible in your savings.
• Use a 401(k) rollover: If you switch employers, avoid paying income taxes on an early withdrawal by moving the money to another pre-tax retirement account within 60 days of withdrawal.

If you have low income, you should also look into the Retirement Savings Contributions Credit, or “Savers Credit,” for a 401k tax deduction that can reduce your annual tax bill. This credit allows you to claim up to 50% of the first $2,000 you contribute.

Other Methods to Reduce Your Taxable Income

Contributing to a 401(k) isn’t the only way to reduce your tax bill. There are so-called tax loopholes, or legal ways to reduce your federal, state or local tax bill, including through tax credits, retirement plans and savings accounts. Here are a few to consider:

• Contribute part of your income to a Health Savings Account (HSA) or a Flexible Spending Account (FSA).
• Make contributions to a pre-tax retirement account, such as an IRA.
• If you have self-employment income, claim your business expenses.
• For homeowners, deduct your mortgage interest on your tax return.

Talk to a Professional to Learn How to Reach Your Financial Goals

Navigating retirement accounts and taxes can be confusing, but you shouldn’t let that stop you from saving. Plus, there are experts who can help, so you don’t have to be an expert. You can get support with retirement planning from an account or tax professional, or even from your employer’s plan representative.

There’s also help available for overcoming present-day financial challenges. Credit counseling can be a free or low-cost resource for dealing with issues like debt management and bad credit and more.