Are Traditional 401(k)s Tax Deferred?

A traditional 401(k) plan is a tax-deferred retirement savings vehicle offered by many employers. With this employer-sponsored plan, you elect to have a percentage of your paycheck automatically deposited into the account. The contributions and any investment earnings they generate are not taxed until you withdraw them in retirement.

How Tax Deferral Works with a Traditional 401k

When you contribute to a traditional 401(k), the funds are taken from your paycheck before federal and some state income taxes are calculated. These “pre-tax” contributions lower your current taxable income for the year. For instance, if your annual salary is $60,000 and you contribute $6,000, your taxable income is reduced to $54,000, resulting in a lower income tax liability for that year.

Once in your account, any earnings from investments, such as dividends, interest, or capital gains, are not subject to annual taxes. This allows the full value of your earnings to be reinvested, a process that can enhance the account’s growth over several decades. This tax-deferred growth is a feature for long-term savings.

The Roth 401k Alternative

Many employers now offer a Roth 401(k) option, which uses a different approach to taxation. Unlike a traditional 401(k), contributions are made with “post-tax” dollars, meaning you pay income taxes on them in the year they are made. They do not lower your current taxable income.

The benefit of this structure is that qualified withdrawals from a Roth 401(k) are tax-free. This applies to both your contributions and any investment earnings. For a withdrawal to be qualified, the account must be open for at least five years, and you must be age 59½ or older.

A detail concerns employer contributions, such as a company match. Historically, matching funds from an employer were deposited into a separate, pre-tax account. The SECURE 2.0 Act allows employers to let employees designate matching contributions as Roth contributions. If an employee chooses this, the match becomes taxable income in the year it is contributed but will be tax-free upon withdrawal.

Tax Treatment of Withdrawals

The tax implications of withdrawing funds from a 401(k) depend on the account type and your age. For a traditional 401(k), distributions after age 59½ are taxed as ordinary income. The amount withdrawn is added to your other income for the year and taxed at your marginal tax rate. In contrast, qualified distributions from a Roth 401(k) are not taxed.

Taking money out before age 59½ is an early withdrawal and has tax consequences. For a traditional 401(k), the withdrawn amount is subject to ordinary income tax plus an additional 10% penalty. Exceptions to this penalty include total and permanent disability, certain medical expenses, or leaving a job in or after the year you turn 55. The SECURE 2.0 Act also allows for penalty-free emergency distributions up to $1,000 per year.

The IRS mandates that you begin taking withdrawals from your retirement accounts at a certain age. These are called Required Minimum Distributions (RMDs). For traditional 401(k)s, you must start taking RMDs by April 1 of the year after you turn 73; this age is scheduled to increase to 75 in 2033. Failing to take the full RMD can result in a penalty of 25% of the shortfall, though this can be reduced to 10% if the error is corrected in a timely manner. In contrast, Roth 401(k)s are not subject to RMDs during the original owner’s lifetime, a change that aligns them with Roth IRA rules.