Tax-Savvy Retirement: Mastering Your 401(k) Tax Implications

When it comes to investing for your financial future, understanding the tax consequences is important to growing wealth. 

Because it’s not just what you make, it’s what you keep, that counts. 

How tax savvy are you with regards to your 401(k)? 

Are you aware of the 401(k) tax implications on withdrawals? Or the real benefit of growing your savings tax-deferred? 

Keep reading for more on 401(k) tax implications and how they may or may not impact your future.

#1 Tax-Deferred Contributions

401(k) tax implications

Contributions to a traditional 401(k) are made before taxes are withheld, which reduces your taxable income. 

This means you don’t pay income taxes on the contributions immediately.

You get a tax break for every dollar that you invest into your 401(k) with pre-tax dollars. 

For example, if you earn $50,000 per year and put 3% of your pay into your 401(k), your investment in your 401(k) would be $1,500.

This $1,500 drops your taxable income down to $48,500.

In some cases, it is even possible for your 401(k) contributions to push you into a lower tax bracket, which may result in paying a lower tax rate.

[Related Read: What to Know Before You File 2023 Taxes]

#2 No Deductions on Tax Returns

401(k) tax implications

Unlike other retirement accounts, you do not need to deduct 401(k) contributions on your tax return. 

The contributions are already taken out of your paycheck before taxes are applied.

This means you save money on taxes today.

Turbo Tax explains, “At the end of the year, when you receive your W-2 form that shows your earnings, you will notice that your wages subject to federal income tax are lower because of your 401(k) plan contributions.”¹

[Related Read: A Good Way to Spend Tax Refunds Wisely]

#3 FICA Taxes

401(k) tax implications

Although you don’t pay income taxes on 401(k) contributions, you still pay FICA taxes on your payroll contributions.

FICA taxes fund Social Security and Medicare programs.

Your FICA taxes are calculated based on your paycheck amount, which includes your 401(k) contribution.

Keep in mind that even though your taxes go toward funding Social Security and Medicare, you will likely still need more money during retirement to cover costs.

Do not plan to rely solely on Social Security and Medicare.

[Related Read: Are You Saving Enough to Cover These Retirement Expenses?]

#4 Tax-Deferred Growth

401(k) tax implications

The investments within your 401(k) grow tax-deferred, meaning you don’t pay taxes on the earnings until you withdraw the money.

This means any income that is gained over time from your investments is tax-deferred.

When you contribute to a 401(k), your money earns interest, and that interest compounds over time – you earn returns on your returns. 

The longer your money is invested, the more it may grow.

Keep in mind that 401(k) plan participants can rebalance their assets to take advantage of potential growth opportunities, which means boosting your savings even more!

[Related Read: 5 Perks of Saving for Retirement in a 401(k)]

#5 Taxable Withdrawals

401(k) tax implications

When you withdraw money from a traditional 401(k), it is taxed as regular income in the year you withdraw it. 

And you pay taxes on the withdrawals at your current income tax rate.

If you want to take a withdrawal from your 401(k), you need to be at least age 59½ to avoid paying an early withdrawal penalty to the IRS.

These withdrawals are subject to ordinary income tax on the amount you withdraw plus a 10% early withdrawal penalty.

[Related Read: Why a 401(k) Withdrawal Should Be Your Last Resort]

#6 Roth 401(k) Contributions

401(k) tax implications

With a Roth 401(k), your contributions are taxed when they go into the plan.

Contributions to a Roth 401(k) are made after income taxes are withheld, so you pay taxes on the contributions upfront. 

However, once your money is invested, your contributions and any earnings grow tax-free and you will not be taxed when you withdraw money from your Roth 401(k) plan. 

Plus, all withdrawals made during retirement are tax-free – including contributions and earnings. 

This may provide significant savings for those expecting to be in a higher tax bracket during retirement.

[Related Read: Should I Consider the Roth 401(k)?]

#7 Tax Benefits in Retirement

401(k) tax implications

When you start withdrawing funds during retirement, you’ll need to pay taxes on both the contributions and the earnings, and they are subject to ordinary income tax rates.

However, the tax benefits of a 401(k) plan are designed to help you save for retirement. 

By deferring taxes until retirement, you may be in a lower tax bracket than you would have been when you initially made the contributions.

This results in a lower tax bill on withdrawals.

[Related Read: Pros and Cons of a Roth 401(k): Key Differences and Tax Implications]

#8 Employer Contributions

401(k) tax implications

Employer contributions to a 401(k) are generally not taxable to you when made, but you will pay taxes on them when you withdraw the money.

Employee matching contributions are tax-deferred, but these matching contributions are taxed when you withdraw money in retirement.

Your 401(k) company match counts toward your total contribution limit.

[Related Read: 4 Ways to Potentially Maximize Your 401(k) Company Match]

#9 Catch-up Contributions

401(k) tax implications

Employees with 401(k)s can contribute up to $23,000 for 2024.

For those 50 and older, there is an additional catch-up contribution limit, which may help prepare for retirement.

For 2024, those ages 50 and older, can utilize catch-up contributions up to $7,500 – for a total of $30,500. 

[Related Read: Retirement Plan Contribution Limits for 2024]

#10 Early Withdrawals

401(k) tax implications

Withdrawing money from a 401(k) before age 59½ may result in penalties and taxes on the withdrawals.

The IRS requires automatic withholding of 20% of a 401(k) early withdrawal.

Along with the withholding taxes, the IRS will also hit you with a 10% penalty if you’re under the age of 59½ on all funds withdrawn when you file your tax return.

The amount withdrawn will also be taxed as ordinary income for the year the money was taken out, which could push you into a higher tax bracket and force you to pay even more taxes.

Let’s say you’re under 59½ and you withdraw $15,000 from your 401(k). 

You will wind up having 20% plus the penalty withheld, leaving you with only about $10,500 of the $15,000 early withdrawal. 

[Related Read: 401(k) Early Withdrawals May Cost You More Than You Think]

Make Sure to Seek Professional Advice

401(k) tax implications

Not only do you need to understand the 401(k) tax implications, but you also should seek advice from a professional.  

This is your retirement we’re talking about – and every dollar you keep helps. 

Reach out to your CPA or accountant for specific tax advice.

A CPA or tax professional can help you determine the 401(k) tax implications regarding your personal financial situation.

In addition, seek help from a financial advisor to determine how to get the most out of your 401(k) plan.

Have questions or concerns about your 401(k) performance?
Book a complimentary 15-minute 401(k) strategy session with one of our advisors.

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