Introduced in 1978, the 401(k) has grown to become the most popular workplace retirement savings plan in the U.S. How is a 401(k) taxed? Several factors influence the tax treatment of your 401(k) withdrawals or distributions in IRS lingo.
Nobody wants to get into trouble with the IRS. Even though you want to minimize your tax liability and boost your tax refunds, the maneuvers should always align with IRS guidelines. You should be extremely careful about rolling the dice with the IRS on something as important as your retirement nest egg.
Therefore, if you have a 401(k) plan at work or anticipate inheriting a 401(k) account from someone, it’s important to know the tax issues related to the plan so that you can avoid potentially costly mistakes.
There are various 401(k) plan types and taxes.
There are two kinds of 401(k) plans. There's the traditional 401(k) and Roth 401(k). With the traditional plan, the contribution is taken from your paycheck before taxes. As a result, you get to pay less in taxes during your work years but taxes will impact withdrawals.
With a Roth 401(k), you contribute to the plan after paying taxes on your paycheck. As a result, you settle with the IRS now for tax-free withdrawals in the future.
The standard 401(k) contribution limit in 2022 is $20,500. If you're older and you need to catch up on retirement savings, you can put up to $27,000 in a 401(k) account. If you have a company match, what the company contributes to your account doesn’t count against your individual limit.
How is a traditional 401(k) withdrawal taxed?
If you’re taking distributions after you're 59 years old, the money gets taxed at your current tax bracket. But if you’re taking early withdrawals, a 10 percent penalty applies in addition to the tax.
A Roth 401(k) with company match is taxed differently.
While Roth 401(k) withdrawals are generally tax-free, there's a catch if you received a company match. The contribution made by the company is treated as ordinary income and gets taxed at your applicable tax rate. Also, taking distribution from a Roth 401(k) plan before it’s at least five years might expose you to taxes and penalties.
You can minimize the tax on an inherited 401(k) plan.
You can inherit a 401(k) plan from a spouse, parent, or someone who named you as a beneficiary at their death. What you do with the inherited account can impact how it gets treated for tax purposes. However, there are ways you could minimize the tax impact on an inherited retirement savings plan.
If you’re the account owner's spouse, you can roll over the funds in the inherited 401(k) into your own 401(k) plan or IRA. For other beneficiaries, you might be able to withdraw the money in a lump sum or leave it there and instead take a regular distribution.
When you inherit a 401(k) plan, you become responsible for paying the applicable taxes. You won’t have to worry much of taxes on withdrawals on an inherited Roth account type. For the traditional account type, you’d pay taxes at your income tax rate.
If you’re inheriting a 401(k) plan from a parent or someone else, you can minimize the taxes and penalties by getting the money out early. Money left for more than 10 years in an inherited 401(k) becomes subject to a 50 percent penalty.