What is 401(k) and How does it work? A Complete Guide

When it comes to most 401(k) plans, associated taxes are only levied on withdrawals. Typically 401(k) plans are tax-advantaged, meaning that the contributions or gains made through this account are taxable until the owner makes a withdrawal.

These tax rules not only make 401(k) plans a good tool to save for retirement, but they are also a great tool to lower your tax bill. To take full advantage of these tax benefits, there are a few rules and strategies that you should know. This post outlines how 401(k) taxes work.

Contribution Rules

Contributions to a traditional 401(k) plan go directly from your paycheck before the IRS can tax them. Let’s say, for example, that your pre-tax earning is $2,000 and you contribute $200 from it to your 401(k), you’ll only be taxed on the remaining $1,800. 

• For 2020 and 2021, the contribution limit for a 401(k) plan is up to $19,500 per annum. This increases to $26,000 if you’re 50 or older.
• You will still have to pay all taxes associated with Medicare and Social Security on your 401(k) payroll contributions. 
• The annual contribution limit applies to all of your 401(k) account contributions combined, regardless of how many accounts you may have.

Tax on Withdrawal

With traditional 401(k)s, the money you withdraw is taxed as regular income in the same year that you take the distribution. Withdrawing from this account before retirement can result in a penalty. You can begin taking out money from your traditional 401(k) without paying a fine when you reach the age of 59½.

• To withdraw money without penalty, your Roth 401(k) should be at least five years old. You have to be at least 59 and a half years old.
• If you’re already retired but haven’t touched your 401(k), it is required that you start taking the minimum distributions when you are 72.
• If you fail to take the minimum distribution at the specified age limit, the IRS can penalize you up to 50% of the balance.
• You can take out more than the minimum required distribution.

Tax on Early Withdrawal

In the case of traditional 401(k)s, there are three major consequences of withdrawing money before you reach the age of 59½:

1. The IRS will withhold taxes. It will automatically withhold about  20% of a 401(k) early withdrawal. So if you take out $1,000 from your 401(k) when you are 40, you may only get around $800.
2. The IRS will charge a penalty. If you take out money from your 401(k) before you’re 59½ years old, the IRS typically levies a 10% penalty on you when you file your return. 

Ways to Lower Your 401(k) Taxes

1. You should wait as much as you can before taking out money from your account. Withdrawals are the trigger for taxes.
2. If you have to withdraw money early from a 401(k), check if you are eligible for an exception which may help you avoid paying a penalty.
3. Check if you are eligible for the Saver’s Credit on your contributions.
4. Keep a close eye on how you roll over your account. Rolling over a 401(k) plan into another tax-advantaged account typically won’t trigger taxes, that is if you manage to transfer the money into the new account within 60 days. 
5. Instead of taking an early withdrawal, you can take a loan from your 401(k). Keep in mind that not all 401(k) plans give you loans. Typically these types of loans need to be repaid within five years.