Does a 401(k) Get Taxed? How Taxation Works

A 401(k) is an employer-sponsored retirement savings plan, named after the section of the U.S. Internal Revenue Code that established it. It allows employees to contribute a portion of their salary, often with employer contributions, into an investment account for future use. Understanding how a 401(k) is taxed is important, as tax implications occur at different stages of the retirement savings journey.

Taxation of Contributions

The tax treatment of money placed into a 401(k) depends on the type of plan offered by an employer. Traditional 401(k) plans accept pre-tax contributions, meaning the money is deducted from an employee’s paycheck before federal income taxes are calculated. This reduces the employee’s current taxable income, providing an immediate tax benefit in the year the contribution is made. For instance, if an individual contributes $10,000 to a traditional 401(k), their taxable income for that year is lowered by that amount.

In contrast, Roth 401(k) plans are funded with after-tax contributions. This means taxes are paid on the income before it is contributed to the account, offering no immediate tax deduction. While the immediate tax benefit of a Roth 401(k) is absent, this approach sets the stage for potential tax-free withdrawals in retirement. Employer matching contributions, if offered, are typically made on a pre-tax basis, even to a Roth 401(k), and are taxed upon withdrawal.

Taxation During Investment Growth

Once contributions are made to a 401(k) account, the investments grow over time. For traditional 401(k)s, this growth occurs on a “tax-deferred” basis. This means that any earnings, such as interest, dividends, or capital gains, are not taxed annually as they accumulate within the account. Taxes on these gains are postponed until the money is withdrawn, typically during retirement.

Roth 401(k)s offer a different advantage during the investment growth phase. Their earnings grow “tax-free,” provided certain conditions are met upon withdrawal.

Taxation of Withdrawals

The taxation of 401(k) withdrawals varies based on account type and distribution timing. For a traditional 401(k), all withdrawals in retirement are generally taxed as ordinary income. This means the entire amount withdrawn, including both contributions and investment gains, is subject to federal income tax at the individual’s prevailing tax rate in the year of withdrawal. Qualified withdrawals from a Roth 401(k), however, are completely tax-free. To be considered qualified, withdrawals must occur after the account holder reaches age 59½ and after a five-year holding period has passed since the first contribution was made.

Early Withdrawals and Penalties

Withdrawing funds from a 401(k) before age 59½ generally incurs both ordinary income tax and an additional 10% early withdrawal penalty on the taxable portion of the distribution. For example, if $10,000 is withdrawn from a traditional 401(k) before age 59½ without an exception, it would be subject to income tax plus a $1,000 penalty. While the penalty primarily applies to the taxable portion of traditional 401(k) withdrawals, for Roth 401(k)s, the 10% penalty and income tax generally apply only to the earnings portion if the withdrawal is not qualified. There are specific circumstances under which the 10% early withdrawal penalty may be waived, although income tax typically still applies to traditional 401(k) distributions. Common exceptions include withdrawals due to total and permanent disability, unreimbursed medical expenses exceeding a certain percentage of adjusted gross income, or separation from service at age 55 or older from the employer sponsoring the plan.

Required Minimum Distributions (RMDs)

Required Minimum Distributions (RMDs) mandate that account holders begin withdrawing funds from their retirement accounts once they reach a certain age. For most traditional 401(k)s, RMDs generally start in the year an individual turns age 73. These distributions are taxed as ordinary income, similar to regular retirement withdrawals. Roth 401(k)s generally do not have RMDs for the original owner during their lifetime, offering flexibility in how long the funds can remain invested and continue to grow tax-free.