How is a 401(k) Taxed?



Save on your taxes and save for retirement.


That's the advantage I hear people share when promoting a 401(k). It sounds good but it is good to understand how it works for you. I am all about making the tax law work for you. So let me walk you through how a 401(k) affects your taxes when you contribute and make a withdrawal.

What is a 401(k)?


A 401(k) is a defined contribution plan used to save for retirement. It gets its name from section 401(k) of the Internal Revenue Code (IRC). This plan has tax advantages for individual contributions.


401(k)s are typically employer-sponsored and the employer matches the employee's contribution up to a certain amount.


Let's say that your employer offers a 401(k) match up to $5,000. That means if you contribute $5,000 to your 401(k) they will also contribute that amount for that year.

However, if you are self-employed you can still open a solo 401(k). There are 5 different types of 401(k) plans. They are:

We are going to focus on 2 types of 401(k)s in this article, a Traditional and Roth 401(k). Each 401(k) has different tax advantages that distinguish them from each other.


What is a Traditional 401(k)?


A Traditional 401(k) is a retirement account where employee contributions are tax-free. This means that the money you contribute reduces your taxable income.

Let's say that Michael contributes has a salary of $60,000 and a traditional 401(k). His employer pays him every other week and he contributes $500 to his 401(k) each time. That means he contributes $13,000 total and that amount of his income is not taxed. His taxable income is $47,000, $60,000 minus $13,000.

No taxes are due on the money contributed or the investment earnings until the employee withdraws it. Yes, the contributions do grow with interest! The money is usually withdrawn during retirement.


What is a Roth 401(k)?


Contributions to a Roth 401(k) are not tax-free. This means that they come after you have already paid taxes on the amount. Your taxable income is not lowered at the end of the year from contributing to a Roth 401(k).


So what is the benefit?

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When you withdraw the money during retirement you will not pay any additional taxes on your contribution or the earnings. Interest-free earnings? Yes!


Let's say Janet has an $85,000 salary and contributes to her Roth 401(k). She contributes $750 each paycheck, totaling $19,500. Even though she has contributed to a 401(k) her taxable income is not reduced because it is a Roth 401(k). However, after she retires she will not pay taxes on the money from her Roth 401(k) when she withdraws it.


How much can I put in my 401(k)?


The amount that you can contribute to your 401(k) as an employee goes up each year for inflation. For 2022 individuals under the age of 50 can contribute $20,500 for the year. More mature individuals, 50 and older can contribute an additional $6,500. We call this a catch-up contribution.

If the employer also contributes to the account there is also a limit. For 2022 the combined employer-employee contributions cannot be more than $61,000 for those under 50. If you are 50 or over and including a catch-up contribution the limit is $67,500.


It's best to consult a financial advisor when determining how much you need to contribute. They can not only guide you in opening an account but also help you reach your retirement savings goals.

How old do I have to be for a 401(k) withdrawal to be tax-free?


If you are not retirement age when you withdraw from your 401(k) you will pay a tax penalty. This tax penalty is 10% of the amount you have withdrawn. So let's say you made a withdrawal of $20,000. Your tax penalty would be $2,000.


The retirement age is 59 1/2. There are certain scenarios in which the IRS will allow you to make a withdrawal without paying the 10% penalty. Speak without your tax professional before making a withdrawal from your 401(k) to see if you qualify for an early withdrawal.

You will pay taxes on a withdrawal from a Traditional 401(k) no matter what age you are. Once you reach 59 1/2 you will no longer have to pay the early distribution tax penalty on your Roth withdrawals. They will be completely tax-free.


Now that you have a better understanding of how each plan works for taxes, which do you think is best?


Maybe you haven't been able to consider that yet because you're 401(k) has gotten you in a tax bind. If that is the case, take a deep breath. Your life isn't over.


Planning for retirement can be tricky, especially if you do not have a financial advisor and tax professional on your team. Did you pull from retirement and end up with a tax bill you weren't expecting? Maybe your provisional income was too high so your social security became taxable. You may just need to adjust how much tax is withheld from your distributions.


It is an easy fix! Now, let's focus on the tax bill. Can you not pay it today? That is okay too. If you owe the IRS $20,000 or less I highly recommend my e-book, Guaranteed Payment Plan. I'll guide you through how to set up a payment plan online or by phone that you can pay in 36 months.



Don't let that tax bill keep you from living your life. For more information on retirement and taxes check out my podcast, Tax Relief with Timalyn Bowens. In episode 13 I discuss retirement income and taxes. Grab a pen and paper when you tune in because back taxes shouldn't ruin your life!

 

Timalyn S. Bowens EA is America's Favorite EA and Louisville's Tax Expert that will work hard to find a customized legal solution for you! As an Enrolled Agent licensed through the Internal Revenue Service Timalyn is able to fight the IRS for taxpayers in all 50 states.


When you are facing questions regarding your personal or business taxes, working with a professional makes all the difference. At Bowens Tax Solutions, we serve our Louisville-area neighbors by providing the tax services and knowledge needed to succeed. We are here to assist you with your tax issues and preventative care. Visit our website at www.bowenstaxsolutions.com for more information.

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