401(k) Tax Rules: Withdrawals, Deductions & More
If you’re building your retirement saving, 401(k) plans are a great option. These employer-sponsored plans allow you to contribute up to $19,000 in pre-tax money per year. Some employers will also match some of your contributions, which means free money for you. Come retirement, though, your withdrawals are subject to income taxes and other rules. Here’s what you need to know about how 401(k) contributions and withdrawals are taxed.
Do you Pay Tax on 401(k) Contributions?
A 401(k) is a tax-deferred account. That means you do not pay income taxes when you contribute money. Instead, your employer withholds your contribution from your paycheck before the money can be subjected to income tax. As you choose investments within your 401(k) and as those investments grow, you also do not need to pay income taxes on the growth. Instead, you defer paying those taxes until you withdraw the money.
Keep in mind that while you do not have to pay income taxes on money you contribute to a 401(k), you still pay FICA taxes, which go toward Social Security and Medicare. That means that the FICA taxes are still calculated based on the full paycheck amount, including your 401(k) contribution.
Do You Need to Deduct 401(k) Contributions on Your Tax Return?
You do not need to deduct 401(k) contributions on your tax return. In fact, there is no way for you to deduct that money.
When employers report your earnings at the end of the year, they account for the fact that you made 401(k) contributions. To give you an example, let’s say you have a salary of $50,000 and you contribute $5,000 into a 401(k) account. Only $45,000 of your salary is taxable income. Your employer will report that $45,000 on your W-2. So if you try to deduct the $5,000 when you file your taxes, you will double count your contributions.
How Much Tax Do You Pay on 401(k) Distributions?
A withdrawal you make from a 401(k) after you retire is officially known as a distribution. While you’ve deferred taxes until now, these distributions are now taxed as regular income. That means you will pay the regular income tax rates on your distributions. You pay taxes only on the money you withdraw. If you withdraw $10,000 from your 401(k) over the course of the year, you will only pay income taxes on that $10,000. It is possible to withdraw your entire account in one lump sum, though this will likely push you into a high tax bracket for the year so it’s smart to take distributions more gradually.
The good news is that you will only have to pay income tax. Those FICA taxes (for Social Security and Medicare) only apply during your working years. You already paid those when you contributed to a 401(k) so you don’t have to pay them when you withdraw money later. (Indeed, now is about the time you’ll start to see the benefits of paying these taxes, when you start using Social Security and Medicare.)
State and local governments may also tax 401(k) distributions. As with the federal government, your distributions are regular income. The tax you pay depends on the income tax rates in your state. If you live in one of the states with no income tax, then you won’t need to pay any income tax on your distributions. So depending on where you live, you may never have to pay state income taxes on your 401(k) money.
Taxes for Making an Early Withdrawal From a 401(k)
The minimum age when you can withdraw money from a 401(k) is 59 ½. Withdrawing money before that age results in a penalty worth 10% of the amount you withdraw. This is in addition to the federal and state income taxes you pay on this withdrawal.
There are exceptions to this early withdrawal penalty, though.
If you want to remove money from a 401(k) account without paying taxes, you will need to meet certain criteria. According to the IRS, you generally don’t have to pay income tax or an early withdrawal penalty if you experience “an immediate and heavy financial need.” One situation where this may apply is when you have medical expenses that aren’t reimbursed by your insurance and which exceed 10% of your adjusted gross income. If this happens, you don’t have to pay taxes on the money you withdraw to cover that financial need. There are also other exceptions, such a for disabled taxpayers. The IRS provides a more complete list of situations where you won’t pay tax on early withdrawals.
The big caveat here is that the amount you can withdraw tax-free is exactly enough to cover the cost of this financial need. And you’ll still pay the full income tax on your withdrawal; only the 10% penalty is waived.
Taxes on Employer Contributions to Your 401(k)
In addition to your contributions, an employer may also put money into your 401(k). Once that money is in your account, the IRS treats it the same as your contributions. You won’t pay any taxes while the money is in your account, but you will pay income taxes when you withdraw it. Unlike your own contributions, you don’t pay any payroll taxes when your employer contributes to your account. It’s truly free money. It doesn’t even count toward the $19,000 contribution limit.
Taxes on Rolling Over a 401(k) Account
There are a few instances where you may want to transfer funds from an employer’s 401(k) into another account. The most common situation is when you leave an employer and want to transfer funds from your previous employer into your new employer’s 401(k), or into your own individual retirement account (IRA).
Whenever you withdraw money from a 401(k), you have 60 days to put the money into another tax-deferred retirement plan. If you transfer the money within 60 days, you will not have to pay any taxes or penalties on your withdrawals. You will need to say on your tax return that you made a transfer, but you won’t pay anything. If you don’t make the transfer within 60 days, the money you withdrew will add to your gross income and you will have to pay income tax on it. You will also pay any applicable penalties if you withdrew before age 59 ½.
If you don’t want to worry about missing the 60-day deadline, you can make a direct 401(k) rollover. This means the money goes directly from one custodian (for instance, the 401(k) provider) to another (for instance, a brokerage handling your IRA) without ever being in your hands.
Finally, note that if you’re rolling over a 401(k) into a Roth IRA, you’ll need to pay the full income tax on the rolled-over amount. However, there’s no 10% penalty for doing so before 59 ½.
Taxes on Other Types of 401(k) Plans
All of the information above applies to traditional 401(k) plans. However, there are variations on the traditional 401(k). Some of these have different rules on taxation.
SIMPLE 401(k) plans and safe harbor 401(k) plans function mostly the same as far as employee taxes are concerned. They differ mostly in that employers have to make certain contributions. SIMPLE 401(k) plans also have a lower contribution limit.
The other type of 401(k) to note is a Roth 401(k). These work quite differently from traditional 401(k) plans. All contributions you make to a Roth 401(k) come from money that you have already paid payroll and income taxes on. Since you pay taxes before you contribute, you do not need to pay any taxes when you withdraw the money.
It’s advantageous to use a Roth 401(k) if you are in a low income tax bracket and expect that you will find yourself in a higher bracket later in your life. This is very similar to why you might want a Roth IRA.
A Note on Individual Retirement Accounts (IRAs)
If your employer doesn’t offer a 401(k) and you decide to contribute to a traditional IRA instead, your taxes will work very similarly. However, your employer doesn’t manage your IRA. You are responsible for making contributions, so your employer won’t consider any of those contributions when reporting your earnings at the end of the year. Because your employer isn’t excluding IRA money from your earnings, you will need to deduct your contributions on your tax return if you want to get the tax benefits. One big difference with 401(k) plans and IRAs is that IRAs have a much lower contribution limit. You can only deduct $5,500 in IRA contributions for the 2018 tax year, and $6,000 in 2019. There are also income limits above which you can’t contribute this full amount.
The Takeaway
Traditional 401(k) plans are tax-deferred. You don’t have to pay income taxes on your contributions, though you will have to pay other payroll taxes, like Social Security and Medicare taxes. You won’t pay income tax on 401(k) money until you withdraw it. Since your employer considers your contributions when calculating your taxable income on your W-2, you don’t need to deduct your 401(k) contributions on your tax return.
Come retirement, all withdrawals you make are treated as regular income; along with other sources of income, you pay income tax according to your income tax brackets for the year. There are also Roth 401(k) plans, which work differently. With these plans, you pay income tax before you contribute but then you don’t have to pay any taxes when you withdraw the money.
Tips to Help You Plan for Retirement
Your retirement plan should account for medical expenses. One option to help you plan for medical costs is a health savings account (HSA). HSAs are tax-deferred just like 401(k) plans. However, you don’t have to pay any income taxes on withdrawals from an HSA as long as you use the withdrawals for medical expenses. Check out our guide to HSAs and whether you should consider one.
Want to create a financial plan that grows your money and provides for a secure retirement? You might benefit from talking to a financial advisor. A financial advisor can sit down with you, look over your entire financial situation, and help you create a roadmap for your future. Advisors can also help with specific situations, like planning an estate and planning your taxes. To help you find an advisor, we suggest using this free financial advisor matching tool. It will consider your financial situation and need, then recommend up to three advisors in your area who can help you meet your goals.
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