A 401(k) plan lets you contribute part of your salary towards your retirement savings over your working years. These contributions are then invested in various investment options like mutual funds, bonds, and other securities. Some of the investments you hold in your 401(k) pay dividends income in specific periods of the year.
401(k) plans pay dividends either quarterly, bi-annually, or annually. The key investments that pay dividends are mutual funds and company stock. When a mutual fund pays dividends, these funds are reinvested into more shares of the fund. If you hold company stock in your 401(k), you may have a choice of receiving dividend payments directly or reinvesting the dividends into more shares of the stock.
What are dividends?
Dividends are the payouts made to shareholders by companies that are thriving financially. When publicly traded companies earn revenue, they share part of the profits earned in a specific period by distributing dividends to shareholders. Shareholders earn a specific dividend amount for each share of stock they hold. In the stock market, dividends provide investors with a steady income, but they must pay tax on the dividend payments.
If you have a 401(k) plan, you may receive dividend income payments depending on the investment options you have invested in. If your employer offers company stock to employees, you could use your 401(k) money to invest in company stock. Since 401(k)s offer mutual funds as one of the main investment options, you could earn dividends from both the mutual fund and company stock.
How dividends are treated in a 401(k)
If a 401(k) plan pays dividends to its plan participants, these dividend payouts are treated differently by each employer. Employers can decide to pay dividends by cash or by reinvesting the dividend payments into more shares of company stock or mutual funds.
When you receive dividends from a mutual fund, the plan reinvests these payments in additional shares. This strategy is cost-effective since there are no transaction costs or commissions on dividend reinvestment. Instead, reinvestment increases your total share count and boosts your investment earnings.
If you hold company stock in your 401(k), your employer may give you a choice between taking the dividends in cash or reinvesting the funds in additional shares of company stock.
If you don’t know how your employer treats dividend payments from 401(k), you should check the plan documents for information. You can also check with the human resource department to know how the company pays dividends.
Do you pay tax on 401(k) dividends?
Dividend income is treated differently in a taxable brokerage account and 401(k) account.
If you hold stocks that pay dividends in a taxable brokerage account, you will pay taxes upfront in the year you receive the dividends. For example, if you receive dividend payments in 2022, you will pay taxes on the dividend income when you file 2022 taxes.
However, if you earned dividend income in a 401(k) plan, you won’t pay taxes when the dividend payments are reinvested into more shares of stock. Since a 401(k) is a tax-deferred retirement account, you will only pay taxes when you take a distribution from the 401(k) in retirement. For example, if you received a dividend payment in 2020, and you don't plan to withdraw the money until 2027, you will only pay taxes in 2027 when you take a distribution.
If you chose to have the dividends in your 401(k) paid out to you, the distribution will be considered an income to you, which you must include when filing your tax return for the year.
How to withdraw dividends from 401(k)
When dividend income is reinvested in a 401(k), it remains in your 401(k) until you withdraw money from your 401(k). You can start taking penalty-free distributions when you turn 59 ½. If you stopped working at 55, you will be allowed to start taking penalty-free distributions. If you are 59 ½ or older, the amount withdrawn will be considered an income and you will pay taxes at your tax bracket rate.
However, if you need to withdraw the dividend income from 401(k) before you reach retirement age, you may be allowed to make an early withdrawal. However, not all employers allow early withdrawals, and you will need to check with your 401(k) plan to see if it allows premature withdrawals. If you are allowed to take an early withdrawal from your 401(k), you will pay tax on the withdrawal. You will also pay an additional 10% penalty for early distributions.
Why isn’t my 401(k) plan paying dividends?
If your 401(k) has invested in dividend-paying mutual funds, and you have not received a dividend payout, it could be because the dividend income is automatically reinvested. Most 401(k) plans choose to reinvest the dividend payout into more shares of the mutual fund. You should check with your employer to know how the dividend payments are treated or reinvested.
