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Most 401(k) plans are tax-deferred. This means that you don’t pay taxes on the money you contribute — or on any gains, interest or dividends the plan produces — until you withdraw from the account.
That makes the 401(k) not just a way to save for retirement; it’s also a great way to lower your taxable income. But there are a few rules about 401(k) taxes to know, as well as a few strategies that can get your tax bill even lower.
» Use our 401k calculator to see if you're on track for retirement
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Taxes on 401(k) contributions
Contributions to traditional 401(k) plans are not taxed. The contributions come out of your paycheck before the IRS takes its cut. You’ll sometimes hear this referred to as “pre-tax income,” and it means two things: 1) you won’t pay income tax on those contributions, and 2) the contributions can reduce your adjusted gross income. If you have an employer match, that money won't be taxed, either.
An example of how this works: If you earn $50,000 before taxes and you contribute $2,000 of it to your 401(k), that's $2,000 less you'll be taxed on. When you file your tax return, you’d report $48,000 rather than $50,000.
A few other notable facts about 401(k) contributions:
In 2023, you could contribute up to $22,500 a year to a 401(k) plan. If you're 50 or older, you could contribute $30,000.
In 2024, that limit rises to $23,000. Those 50 or older can contribute up to $30,500.
The annual contribution limit is per person, and it applies to all of your 401(k) account contributions in total.
You still have to pay some FICA taxes (Medicare and Social Security) on your payroll contributions to a 401(k).
Your employer will send you a W-2 in January that shows how much it paid you during the previous calendar year, as well as how much you contributed to your 401(k) and how much withholding tax you paid.
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Taxes on 401(k) withdrawals
If you withdraw the money early
For traditional 401(k)s, there are three main consequences of an early withdrawal or cashing out before age 59½:
Taxes will be withheld. The IRS generally requires automatic withholding of 20% of a 401(k) early withdrawal for taxes. So if you withdraw the $10,000 in your 401(k) at age 40, you may get only about $8,000.
The IRS will penalize you. If you withdraw money from your 401(k) before you’re 59½, the IRS usually assesses a 10% penalty when you file your tax return. That could mean giving the government an additional $1,000 of that $10,000 withdrawal.
You will have less money for later, especially if the market is down when you start making withdrawals. That could have long-term consequences.
There are a lot of exceptions, but you might be able to avoid the IRS’s penalty for early withdrawals from a traditional 401(k) if you:
Receive the payout over time.
Qualify for a hardship distribution with the plan administrator.
Leave your job and are over a certain age.
Are a domestic abuse survivor.
Are getting divorced.
Give birth to a child or adopt a child.
Are or become disabled.
Put the money in another retirement account.
Use the money to pay an IRS levy.
Use the money to pay certain medical expenses.
Were a disaster victim.
Overcontributed to your 401(k).
Were in the military.
Are terminally ill.
Die.
Finally, a provision in the Secure 2.0 Act allows special emergency 401(k) distributions of up to $1,000 per year beginning in 2024. The taxpayer can pay the $1,000 back over a three-year period, and no other distributions can be made until the money is repaid.
» Dive deeper: How 401(k) withdrawals and penalties work
If you withdraw the money at or after age 59½
For traditional 401(k)s, the money you withdraw (also called a “distribution”) is taxable as regular income — like income from a job — in the year you take it. (Remember, you didn’t pay income taxes on it back when you put it in the account; now it’s time to pay the IRS.) You can begin withdrawing money from your traditional 401(k) without penalty when you turn age 59½. The rate at which your distributions are taxed will depend on what federal tax bracket you fall in at the time of your qualified withdrawal.
A few important points:
If you’ve retired, you have to start taking required minimum distributions from your traditional 401(k) account when you're 73 as of 2023.
If you don’t take the required minimum distribution when you’re supposed to, the IRS can assess a penalty of 50% of the amount not distributed.
You can withdraw more than the minimum.
» MORE: See how retirement age is defined
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Taxes on Roth 401(k) plans
Some employers offer another type of 401(k) plan called a Roth 401(k). These savings plans take the opposite approach when it comes to taxation: They’re funded by post-tax income. This means your contributions won’t lower your AGI ahead of tax-filing season.
The biggest benefit of a Roth 401(k) is that because you’re paying taxes on your contributions now, you can withdraw the contributions tax-free later. A few other important notes:
You can begin withdrawing money from your Roth 401(k) without penalty once you’ve held the account for at least five years and you’re at least 59½.
You can withdraw contributions from a Roth 401(k) early if you’ve held the account for at least five years and need the money due to disability or death.
Roth 401(k)s will not require taking RMDs as of January 2024.
Compare Roth 401(k) vs. traditional 401(k)
Traditional 401(k) | Roth 401(k) | |
|---|---|---|
Tax treatment of contributions | Contributions are made pre-tax, which reduces your current adjusted gross income. | Contributions are made after taxes, with no effect on current adjusted gross income. Employer matching dollars must go into a pre-tax account and are taxed when distributed. |
Tax treatment of withdrawals | Distributions in retirement are taxed as ordinary income. | No taxes on qualified distributions in retirement. |
Withdrawal rules | Withdrawals of contributions and earnings are taxed. Distributions may be penalized if taken before age 59½, unless you meet one of the IRS exceptions. | Withdrawals of contributions and earnings are not taxed as long as the distribution is considered qualified by the IRS: The account has been held for five years or more and the distribution is:
Unlike a Roth IRA, you cannot withdraw contributions any time you choose. |
7 ways to reduce your 401(k) taxes
Wait. Consider staying out of your 401(k) account if you can help it. Withdrawals, especially early ones, can trigger taxes.
Look for exceptions. If you must make an early withdrawal from a 401(k), see if you qualify for an exception that will help you avoid paying an early withdrawal penalty.
Consider credits. See if you qualify for the saver’s credit on your contributions.
Know the rules about 401(k) rollovers. Rolling a 401(k) account into another 401(k) or into an IRA usually won’t trigger taxes — if you get the money into the new account within 60 days of when you withdraw the money. Otherwise, the IRS might consider the move a distribution, triggering taxes and maybe even a penalty.
Weigh taking a 401(k) loan vs. a withdrawal. In most circ*mstances, you’ll need to repay the loan within five years and make regular payments. And not all 401(k) plans offer loans. Check with your plan administrator for the rules.
Explore tax-loss harvesting. You might be able to offset the taxes on your 401(k) withdrawal by selling underperforming securities at a loss in some other regular investment account you might have. Those losses can offset some or all of the taxes on your 401(k) withdrawal.
See a tax professional. There are other ways to minimize your 401(k) taxes, too. A qualified tax pro can discuss your options with you.
» Dive deeper: View our list of the best rollover IRA providers
As an expert in personal finance and taxation, I can provide comprehensive insights into the concepts discussed in the article about 401(k) plans and taxes.
Tax-Deferred Nature of 401(k) Plans: Most 401(k) plans are tax-deferred, meaning you don't pay taxes on contributions, gains, interest, or dividends until you withdraw from the account. This feature not only serves as a means to save for retirement but also helps lower taxable income.
Contributions to Traditional 401(k) Plans: Contributions to traditional 401(k) plans are not taxed, representing "pre-tax income." This implies that these contributions reduce your adjusted gross income, providing a tax benefit. Employer matches are also not taxed. The article mentions the 2023 contribution limit of $22,500, increasing to $23,000 in 2024, with higher limits for those aged 50 or older.
FICA Taxes on 401(k) Contributions: While 401(k) contributions are not subject to income tax, FICA taxes (Medicare and Social Security) still apply to payroll contributions.
Taxation on 401(k) Withdrawals: Early withdrawals from traditional 401(k)s before age 59½ are subject to taxes and a 10% IRS penalty. Exceptions exist for circ*mstances such as hardship, leaving a job at a certain age, domestic abuse, disability, and more. The Secure 2.0 Act introduces emergency 401(k) distributions.
Withdrawals at or after age 59½ are taxable as regular income. Required minimum distributions must start at age 73 as of 2023, with penalties for non-compliance.
Roth 401(k) Plans: Roth 401(k) plans are funded with post-tax income. Contributions do not lower adjusted gross income, but qualified withdrawals are tax-free. Roth 401(k)s do not require minimum distributions as of January 2024.
Comparison: Traditional vs. Roth 401(k): Traditional 401(k) contributions are pre-tax, reducing current adjusted gross income. Distributions are taxed in retirement. Roth 401(k) contributions are after-tax, with no effect on current adjusted gross income. Qualified distributions are tax-free.
Strategies to Reduce 401(k) Taxes:
- Delay Withdrawals: Avoiding early withdrawals helps in deferring taxes.
- Exceptions: Explore exceptions to avoid early withdrawal penalties.
- Saver's Credit: Qualify for the saver's credit on contributions.
- Rollovers: Understand rules about 401(k) rollovers to avoid triggering taxes.
- Loan vs. Withdrawal: Consider the implications of taking a 401(k) loan versus a withdrawal.
- Tax-Loss Harvesting: Offset 401(k) withdrawal taxes by selling underperforming securities.
- Consult a Tax Professional: Seek advice from a tax professional for personalized strategies.
In conclusion, understanding the taxation nuances of 401(k) plans and employing strategic approaches can optimize financial outcomes in retirement planning.
