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401(k) tax essentials: What savers need to know
Savers 401(k)

401(k) tax essentials: What savers need to know

Jeff Rosenberger, PhD

💡 Key takeaways:

  • 401(k) plans can have many tax advantages for savers, and different tax rules exist for different types of contributions.
  • Generally, if you don't make a withdrawal from your 401(k), you don't have to report anything in your annual tax filing.
  • If you've made withdrawals from your 401(k), you must report them on your annual tax filing with Form 1099-R.

Finally, it’s everyone's favorite season. No, not spring — we're talking about tax season. If you're saving for retirement with a 401(k), making sense of your plan's tax implications can feel challenging. In this post, we're tackling some of the most frequently asked questions about 401(k)s and taxes, including:  

  • Do you pay taxes when you contribute to a 401(k)?
  • Do you pay taxes when you take money out of a 401(k)?
  • What 401(k) tax forms do I need?
  • Does contributing to 401(k) reduce your taxable income?
  • What are the deadlines and penalties related to 401(k) taxes?

But first, let's start with the basics.

A 401(k) is an employer-sponsored retirement savings plan that can help you save for retirement. 401(k)s also have certain tax advantages, which can depend on the different types of contributions you make.

When you put money into your 401(k), you can make two types of contributions — traditional and Roth. The biggest difference between traditional and Roth 401(k) contributions is when you're taxed. Both types have tax advantages, but contributions to a traditional 401(k) are pre-tax, and Roth 401(k) contributions are post-tax.

With a traditional 401(k), your contributions are pre-tax, which lowers your adjusted gross income the same year you contribute. This means you receive the tax benefit today, and related taxes are deferred until you withdraw your money in retirement. The contributions and their growth will be included as ordinary income when you withdraw them from the plan, unless you roll them over to another plan or IRA.

On the other hand, Roth 401(k) contributions are funded with after-tax money, which means you can withdraw the actual contributions tax-free whenever allowed by the plan. Any growth is tax-deferred, and may even be tax-free if the distribution is a qualified withdrawal when you take it out.

Tax implications of 401(k) contributions

There are two questions we see pop up often when it comes to taxes on 401(k) contributions:

How do traditional 401(k) contributions reduce my taxable income?

As mentioned above, contributions you make to a traditional 401(k) are made with pre-tax dollars; money is deposited directly to your retirement account without getting taxed. Since the contributions are pre-tax, every dollar you save in a 401(k) lowers your taxable income by an equal amount. For example, if your gross annual income is $65,000, and you contribute $10,000 pre-tax dollars into your 401(k), your annual taxable income is actually $55,000 for the year.

Are my 401(k) contributions tax deductible?

No, you can't deduct your 401(k) contributions on your tax form. However, this does not mean your contributions may not have affected your taxable income. Depending on the types of 401(k) contributions you've made, your taxable income may have already been reduced — it's just already reflected on your W-2, so there's no need to report it on your taxes to receive the benefit.

How are my employer’s contributions to my 401(k) taxed?

Taking advantage of your employer's 401(k) match can be a great way to boost your retirement savings. Generally, contributions from your employer are made pre-tax, which means they'll be taxed when you withdraw them.

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Tax implications of 401(k) withdrawals

There are generally two factors for how your 401(k) withdrawals are taxed: your age when withdrawing funds and the contribution type. We've already covered contributions above, so let's dive into age.

In general, you can withdraw funds from your 401(k) when your plan allows, often at a specific age, and anything before that is considered early and has subsequent penalties. So, in summary:

  • Standard withdrawals are distributions on or after the date you turn 59 ½. Standard withdrawals don't have any additional tax penalties.
  • Early withdrawals are those made before you turn age 59 ½. These withdrawals are subject to an additional 10% penalty tax unless you meet one of the IRS exceptions, which include distributions due to death or disability and to cover medical expenses.  

Now, let's dive a bit deeper on early withdrawals.

In general, the IRS assumes that you’ll leave the money you’ve saved in your 401(k) alone until you retire, which is why they let the earnings grow tax-deferred. That said, the IRS recognizes that withdrawals may be necessary in certain circumstances. If you need to take money out of your 401(k) before you turn 59 ½, you may be exempt from the penalty tax if you meet one of the exceptions, including but not limited to:

  • Automatic enrollment refund: Withdrawals requested within 90 days of being automatically enrolled in the 401(k) plan.
  • Birth or adoption: Withdrawals for qualified birth or adoption expenses ($5,000 per child).
  • Death: Withdrawals made by the beneficiary after the passing of the participant.
  • Disability: Withdrawals made after a participant becomes "permanently and totally disabled," as defined by the IRS.
  • Disaster recovery distributions:  Withdrawals made due to a federally declared disaster (up to $22,000).
  • Domestic abuse victim: Withdrawals taken by a victim of domestic abuse up to the lesser of (1) $10,000 or (2) 50% of their vested account balance.
  • Emergency personal expense: Withdrawal taken for personal or family emergency expenses — one per year up to the lesser of (1) their vested account balance or (2) $1,000.
  • Medical expenses: Withdrawals for unreimbursed medical expenses.
  • Pension-linked emergency savings account (PLESA): Withdrawals taken from a PLESA.
  • Qualified military: Withdrawals made when on qualified military duty.
  • Separation from service: Withdrawals made after a participant leaves employment for any reason after age 55 (or age 50 for public safety employees).
  • Terminal illness: Withdrawals made as a result of terminal illness. (Note — these withdrawals must be on or after the date a physician has certified the terminal illness.)

While the IRS grants a penalty exemption when you meet one or more of these requirements, your 401(k) plan determines if you can take a distribution at all. A penalty exemption does not automatically mean you can take money from your 401(k).

Often, the 1099-R provided by your employer won't show that you have an exception to the 10% early withdrawal penalty tax — usually because they don't know that you've met a requirement. If you qualify for one of the exemptions, you can indicate that on your tax filing using IRS Form 5329. Speak with your tax advisor or accountant to determine the forms you must complete when you file your taxes.

Now, let's look at some special cases, including 401(k) loans and rollovers.

Tax implications of retirement plan rollovers

If you want to transfer or “rollover” funds from one retirement account to another, there are typically two ways to do it: direct and indirect.

Direct rollovers

A direct rollover is when you transfer your retirement savings directly to another retirement plan. This can be through a wire, ACH, check mailed directly to the new financial organization, or a check mailed to you but payable to the new financial organization. The key element of a direct rollover is that you won't be able to spend the money or deposit it into a personal account.

With a direct rollover, the amount will not be included in your taxable income and isn't subject to the 10% early withdrawal penalty tax. You will still receive a 1099-R and need to report the rollover on your taxes, but it will not affect the final calculations.

Indirect rollovers

With an indirect rollover, the distribution is paid to you as a standard cash distribution. However, as long as the amount is eligible to be rolled over, you can deposit the distribution to another retirement plan or IRA within 60 days.

The 60-day time frame begins the day after you receive the distribution. If you miss this deadline, the pre-tax portion of the distribution will be included as ordinary income, and you may have to pay a 10% early withdrawal penalty tax on the entire amount of the distribution that was not rolled over unless an exception applies.

Indirect rollovers are like regular cash distributions, so they follow standard state and federal tax withholding rules. If the amount is eligible for rollover, there's a mandatory 20% withholding for federal income tax on any pre-tax amount. In short, your employer has to keep back 20% of the pre-tax amount and forward it on to the IRS as a pre-payment of  federal taxes.

To avoid possible penalties, you'll need to make up both the state and federal withholding out of pocket. Any amount not rolled over will be included as ordinary income (if it is pre-tax) and will be subject to an early withdrawal penalty tax unless an exception applies.

The rules surrounding in-direct rollovers are complex, so let's look at a couple of examples. For these examples, we’ll assume that the entire amount of the distribution is from pre-tax deferrals and that the state the individuals live in does not require withholding on retirement plan distributions.

Sarah takes a distribution of $10,000 and $8,000 is deposited into her personal banking account on March 31. The other $2,000 is withheld and submitted as federal tax withholding. Before May 31 (the 60 day deadline), Sarah Jane deposits $5,000 in her IRA as an indirect rollover. Sarah will include $5,000 as taxable income ($10,000 distribution - $5,000 rollover contribution).
Donna takes a distribution of $10,000 and $8,000 is deposited into her personal banking account on May 10. The other $2,000 gets withheld and submitted as federal tax withholding. Before July 9 (the 60 day deadline), Donna rolls over $10,000 to her new employer's 401(k) plan. To do this she added $2,000 from her personal savings to the $8,000 that was deposited. Because the full $10,000 was rolled over before the 60 day deadline, none of the distribution will be included as taxable income and the $2,000 that was withheld will be refunded or applied to her outstanding tax balance when she files her taxes for the year.

For a deeper dive on rollovers, visit our help center.

Tax implications of 401(k) loans

If you need to tap into your 401(k) savings, you may be able to take a loan from your 401(k). Generally speaking, you'll have five years to repay the loan with interest. If your plan allows 401(k) loans, the interest you'll pay may partially offset the earnings you'd miss out on while the loan amount isn't invested under the plan.

Note that loans are not considered a withdrawal from your plan, provided certain requirements are met. Because they are not withdrawals, the money borrowed from your account is not included in your taxable income and you will not receive a 1099-R reporting the loan amount.

If you don't make the required payments or fail to repay the loan on time, it may be considered in default. Defaulting on a 401(k) loan can result in the loan being "deemed distributed" and taxed as a distribution. This means the entire outstanding pre-tax amount of the loan will be included as ordinary income in the year the deemed distribution occurs. Additionally, the whole amount, including accrued interest, will be subject to the 10% early withdrawal penalty tax unless an exception applies.

It's also important to note that if you leave your job and have an outstanding 401(k) loan, you may need to repay it in full when you leave. In fact, some plans require that all loan payments must be made via payroll deduction. If you no longer have a paycheck from that employer, your loan may go into default because you cannot meet that requirement.

Your plan may also require you to be a current employee to keep the loan active. In some cases, you can roll the loan over to a new retirement plan and continue to make payments. But if you can't roll it over and don't pay it back, the loan will be considered a distribution.

How to report 401(k) contributions and withdrawals on tax returns

Long story short, your personal situation will determine what you’ll need to file. In general, you don’t report contributions to your 401(k) on your tax return; they’re included on your W-2, and have automatically lowered your taxable income for the year.

If you haven't taken withdrawals, distributions, or loans:

Generally, if you've made no withdrawals or rollovers from your 401(k), you don't have to report anything on your tax return. Your contributions are already reflected in your income through your W-2.

That said, even if you haven't made any withdrawals, reviewing your 401(k) for recordkeeping and accuracy is still a good idea. Look at your contributions to ensure you have stayed within the annual limits. This can also be a great time to evaluate how well your 401(k) is performing and consider any changes in contributions or investments for the future.

If you've taken withdrawals, distributions, or loans:

If you've taken withdrawals from your 401(k), you must report them on your annual tax filing.

Whenever you withdraw from your 401(k) plan, your plan administrator will send you a Form 1099-R, which reports distributions from a 401(k) plan. You can use the information on this form — including the total withdrawal and taxable amounts — to assist you in filing your taxes.

If you had a loan deemed distributed, offset, or qualified plan loan offset, you will receive a 1099-R for that amount. The pre-tax portion of the outstanding balance will be considered ordinary income, and the entire amount may be subject to a 10% early withdrawal penalty unless an exception applies.

Understanding the tax implications of your 401(k) plan can feel challenging, but it's manageable if you pay close attention to the requirements. You should always consider consulting with a tax professional and don’t be afraid to ask for support from your 401(k) provider.

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The information provided herein is general in nature and is for informational purposes only. It should not be used as a substitute for specific tax, legal and/or financial advice that considers all relevant facts and circumstances. You are advised to consult a qualified financial adviser or tax professional before relying on the information provided herein.