What Are the Tax Implications of a 401(k) Account?

Like most employees, you might have a 401(k) account through your employer. This retirement plan helps you save money for your later years.

Understanding the tax implications of a 401(k) account helps you make informed decisions about contributions and withdrawals. The following questions and answers can be used as a guide.

What Are Some 401(k) Tax Benefits?

Pre-tax contributions to a traditional 401(k) lower your taxable income, potentially putting you in a lower tax bracket. The earnings grow tax-deferred until withdrawn after age 59 ½.

Conversely, post-tax contributions to and earnings in a Roth 401(k) grow tax-free. Withdrawals are tax-free if you hold the account for at least 5 years, wait until age 59 ½ or later, become disabled, or pass away, and your beneficiary receives the money.

Are 401(k) Contributions Made Pre-Tax?

Contributions to a traditional 401(k) are made using pre-tax dollars. These contributions lower your taxable income by an equivalent amount, resulting in a current-year reduction of your annual income tax liability. You won’t owe income tax until you make withdrawals, typically during retirement.

In contrast, Roth 401(k) contributions are made using after-tax dollars. When you begin taking qualified distributions in retirement, the income is tax-free.

Are 401(k) Contributions Tax-Deductible?

Although contributions to a traditional 401(k) lower your taxable income, they are made with pre-tax dollars and are not tax-deductible. The money is deducted from your paycheck before federal taxes are taken out.

Similarly, contributions to a Roth 401(k) are not tax-deductible. The contributions are made with after-tax dollars and can be withdrawn tax-free.

Are Employer Matches to 401(k) Contributions Taxed?

Employer matches to traditional 401(k) contributions are not taxed when made. However, the matches are taxable upon withdrawal.

Conversely, employer matches to Roth 401(k) contributions are taxed as ordinary income in the year they are made. However, the matches are tax-free if withdrawn after age 59 ½.

How Are the Earnings in a 401(k) Taxed?

The earnings in a traditional 401(k) account grow tax-deferred. You pay ordinary income taxes upon withdrawal.

In contrast, earnings in a Roth 401(k) account grow tax-free. Withdrawals are tax-free if you hold the account for at least 5 years, wait until age 59 ½ or later, become disabled, or pass away, and your beneficiary receives the money.

Is There a 401(k) Tax Penalty?

You can incur a 10% early-withdrawal penalty if you take out funds from a 401(k) before age 59 ½, in addition to regular income tax on the withdrawn amount.

The 10% penalty does not apply if distributions are made before age 59 ½ under any of the following circumstances:

• Timely made to reduce excess contributions

• Timely made to reduce excess employee or matching employer contributions

• Timely made to reduce excess elective deferrals

• Made because of an IRS levy on the plan

• Made on account of a certain disaster for which IRS relief has been granted

• Made to an alternate payee under a qualified domestic relations order (QDRO)

• Made for medical care up to the amount allowable as a medical expense deduction

• Made because of a qualifying disability

• Made after separation from service if the separation occurred during or after the calendar year in which you reached age 55

• Made as part of a series of substantially equal periodic payments beginning after separation from service and made at least annually for your life, your life expectancy, or the joint lives or life expectancies of you and your beneficiary

• Made to a beneficiary or to your estate on or after your death  

Are Taxes Automatically Taken Out of a 401(k) Distribution?

You will owe income taxes after receiving distributions from a traditional 401(k) account. Some plans automatically withhold 20% for taxes. Check with your plan provider to see how yours works.

Conversely, you won’t owe taxes on Roth 401(k) account distributions if you are at least age 59½ and the account has been open for at least five years. 

Is There a 401(k) Inheritance Tax?

Beneficiaries typically are required to pay income tax on distributions from an inherited traditional 401(k) account. The assets are taxed at the beneficiary’s ordinary income tax rate.

In contrast, beneficiaries do not owe income taxes on withdrawals from an inherited Roth 401(k).

*This information is for educational purposes only.