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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 cut your tax bill. 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.
Here’s an overview of how 401(k) taxes work, how a 401(k) can affect your tax return and how to pay less tax when the IRS asks for a cut of your retirement savings.
» Use our 401k calculator to see if you're on track for retirement
Taxes on 401(k) contributions
Contributions to a traditional 401(k) plan 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) they can reduce your adjusted gross income.
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 2022, you can contribute up to $20,500 a year to a 401(k) plan. If you're 50 or older, you can contribute $27,000. In 2023, the contribution limits rise to $22,500 for individuals under 50 and $30,000 for those 50 or older.
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 big 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 another $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. This article has more details, but in a nutshell, you might be able to escape the IRS’s 10% 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 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.
Die.
If you withdraw the money when you retire
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 piper.) 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 account when you're 73.
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.
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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 money 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 money 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 also require taking RMDs.
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. Don’t dip into your 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. Otherwise, the IRS might consider the move a distribution, triggering taxes and maybe even a penalty.
Borrow from your 401(k) instead of making an early withdrawal. Not all 401(k) plans offer loans, though. Also, in most circumstances, you’ll need to repay the loan within five years and make regular payments. Check with your plan administrator for the rules.
Use 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, so find a qualified tax pro and discuss your options.
