401(k) Tax

What Is a 401(k)

A 401(k) is a retirement savings plan sponsored by an employer. It lets workers save and invest a portion of their paychecks before taxes are taken out. 

Earnings in the account grow tax-deferred, meaning you will not pay taxes on them until you withdraw the money in retirement.

Taxes on Employee Contributions

Below are some types of employee contributions:

Income Taxes

Your contributions to a 401(k) are made with pretax dollars, which means they are not subject to income taxes.

FICA Taxes

While you do not have to pay income tax on your 401(k) contribution, you will still have to pay Federal Insurance Contributions Act (FICA) taxes. 

Also known as payroll taxes, FICA taxes are calculated based on the full paycheck amount, which is before the portion for the 401(k) contribution is taken.

Taxes on Employer Contributions 

Employers may make matching contributions to their employees' 401(k) accounts. These contributions are not subject to income tax until they are withdrawn. Unlike your contributions, you would not have to pay FICA taxes on these amounts.

These contributions also do not add up to the 2022 contribution limit of $20,500 or the 2023 contribution limit of $22,500.

401(k) Distribution Taxes

Distribution is when you take money out of your 401(k) after retirement. Below are some types of distribution taxes:

Income Taxes

Since contributions to a 401(k) are tax-deferred, distributions made from the account will now have to be taxed as regular income. You will only have to pay income tax on the amount you withdraw.

For instance, if you are taking out $15,000 from your 401(k), you will only need to pay income tax on that amount.

While taking out cash in a lump sum is possible, it may not be favorable tax-wise. You may want to consider taking out smaller amounts over a period of time to spread out the tax liability.

FICA Taxes

FICA taxes will not apply to 401(k) distributions since you have already paid them back when you made the contributions.

You will begin to enjoy the benefits of FICA taxes when you start using your Social Security and Medicare benefits.

State Taxes

The federal government treats distributions as part of regular income, while state and local governments may or may not collect tax on distributions. Taxes will be based on the income tax rates per state.

It is also important to know that some states do not levy an income tax. These states are Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. 

So, if you live in any of these states, you will not have to pay any income tax on your 401(k) distributions.

401(k) Early Withdrawal Taxes and Exceptions

Taking out money from your 401(k) before you reach the age of 59 1/2 usually comes with a 10% penalty on the taxable amount in addition to regular income taxes.

Even if you live in one of the states that do not have an income tax, you will still have to pay the federal government's 10% early withdrawal penalty.

However, there are a few exceptions to this rule. The IRS may waive the 10% penalty under the following conditions:

• Disability or death of account owner
  
• Medical Expenses Exceeding 7.5% Of the Account Owner’s Modified Adjusted Gross Income (MAGI)
  
• child support
  
• spousal support
  
• military active duty
  
• Rule of 55
  
• Substantially Equal Periodic Payment

Rule of 55

The Rule of 55 exception allows you to take penalty-free withdrawals from your 401(k) starting at age 55, provided you have left your job either through termination, voluntary resignation, or layoff.

This is only applicable if you have a 401(k) through your employer.

Substantially Equal Periodic Payment (SEPP) Exemption

Substantially Equal Periodic Payments, or SEPP, is an IRS-approved method that lets you take penalty-free withdrawals from your retirement account starting at age 59 1/2.

SEPP allows you to take out a set amount of money periodically for a minimum of five years or until you reach age 59 1/2, whichever comes later.

401(k) Rollover Taxes

Rollover is when you move your 401(k) assets to another retirement account, such as your new employer's 401(k) or an Individual Retirement Account (IRA).

There are two types of rollovers: direct and indirect.

Direct Rollover

A direct rollover happens when the assets are moved directly from the old plan to the new plan. A direct rollover saves you from worrying about the 60-day deadline for rollovers.

Indirect Rollover

An indirect rollover is the opposite of a direct rollover in that the assets are first distributed to you instead of transferred directly to the new plan.

With an indirect rollover, you will have to deposit the assets into the new retirement account within 60 days to avoid paying taxes and penalties on the distribution.

If you roll over a 401(k) into a Roth IRA, you will have to pay taxes on the conversion since you are effectively taking a distribution from your 401(k).

Taxes on Other 401(k) Plans

The above information applies to traditional 401(k) plans. Other types of 401(k) plans, such as Roth 401(k), have different tax rules.

For example, with a Roth 401(k), you pay taxes on the contributions but not on the distributions since the money has already been taxed.

SIMPLE 401(k) and Safe Harbor plans are closely similar to the traditional 401(k) in terms of employee taxes. They differ, however, in employer contributions and contribution limits.

Final Thoughts

Traditional 401(k) plans offer many tax advantages that can help you save for retirement. Because they are tax-deferred, you only have to pay taxes on the distributions when you retire. Income taxes, FICA taxes, and state taxes may apply to distributions depending on a few factors.

It is also important to familiarize yourself with early withdrawal penalties and exceptions and the tax rules for rollovers so that you can make the most of this retirement savings tool.

If you have any questions about how taxes work with your 401(k), be sure to speak with a financial advisor or tax professional.

FAQs

1. What are the benefits of a traditional 401(k)?

The main benefit of a traditional 401(k) is that it offers tax advantages. Contributions made to a traditional 401(k) are not subject to income taxes, which can help reduce your taxable income in the current year. The money in your 401(k) also grows tax-deferred, meaning you won't have to pay taxes on the investment gains until you make withdrawals in retirement.

2. What is a Roth 401(k)?

A Roth 401(k) is similar to a traditional 401(k) in that it is sponsored by an employer and offers tax advantages. The main difference is that contributions to a Roth 401(k) are made with after-tax dollars, so you will not get a tax break on the contributions in the current year. However, withdrawals from a Roth 401(k) in retirement are typically tax-free.

3. What is a SIMPLE 401(k)?

A SIMPLE 401(k) is a type of retirement plan that is designed for small businesses. This type of plan offers similar tax incentives to traditional 401(k).

4. What is a Safe Harbor 401(k)?

A Safe Harbor 401(k) is another type of retirement plan that is similar to a traditional 401(k). The main difference is that employers are required to make contributions on behalf of employees. This type of plan also has specific vesting rules.

5.  How much can I contribute to a 401(k)?

For 2022, the contribution limit for a 401(k) is $20,500. If you are 50 or older, you can contribute an additional $6,500 as a catch-up contribution. For 2023, the contribution limit is $22,500, with an additional $7,500 as a catch-up contribution.