Aging happens to us all, and when you’re too old to work as much as you used to (or at all), retirement savings pick up the slack and help you take care of your needs through your hard-earned twilight years. That’s why setting aside part of your paycheck to put into your 401(k) is a great idea, and we advise most people to do it. This is especially true if your employer matches a percentage of your 401(k) contribution—that’s free money!
However, retirement saving strategies can be complex and difficult to understand, especially when the question of taxes comes up. In this blog post, we’ll explore the effects of taxes on 401(k) contributions and withdrawals to help you better understand this crucial component of saving for your future.
Taxes on 401(k) Withdrawal and Contributions
One of the biggest points of confusion surrounding 401(k) accounts is the question—do you pay taxes on 401(k) contributions and withdrawals?
There are taxes on 401(k) dollars, but how and when you pay them depends on the type of account and the nature of the transaction. For example, in a traditional 401(k), the contributions you make come from pre-tax dollars. That means you don’t pay income tax on the money you contribute in the year you make the contributions. Investment earnings such as dividends, interest, and capital gains are also not taxed as long as they remain in the account.
However, investing money this year into your 401(k) does not mean that money is tax-free forever. You see, money invested in a 401(k) is defined as Tax-Deferred Earnings. ‘Tax-Deferred’ means that while you don’t have to pay taxes on them now, you will have to pay taxes on 401(k) withdrawals.
When you finally retire and start withdrawing money from your 401(k), that money is treated the same way ordinary income is—which means it’s subject to income tax just like your paychecks were. If you withdraw funds early, you may also be subjected to a 10% early withdrawal penalty unless you qualify for an exception.
If you have a Roth 401(k), on the other hand, your contributions are made with after-tax dollars, meaning you pay income tax on the money you contribute in the year you make the contributions. However, unlike a traditional 401(k), taxes on 401(k) withdrawals in retirement are tax-free.
Either way, yes, there are taxes on your 401(k), but the nature of your 401(k) account determines whether you pay those taxes upon contribution or withdrawal.
State tax laws also determine how your 401(k) contributions or withdrawals are taxed. These laws differ from state to state. Georgia, for example, has income taxes on pensions, annuities, money drawn from 401(k)s, and other retirement income. However, there are extremely generous tax breaks for seniors that make Georgia a relatively tax-friendly state to retire in.
Are 401(k) contributions tax-deductible?
Whether you are taxed on 401(k) contributions or withdrawals depends on your type of 401(k). For example, a traditional 401(k) does reduce your current income tax liability, because your contributions are made with pre-tax dollars. Roth, again, is the opposite—your contributions are made with after-tax dollars, so they don’t reduce your current income tax liability.
So, in other words, the answer to the question of “Are 401(k) contributions tax-deductible?” is “yes” for a traditional account and “no” for a Roth account. This means traditional 401(k) tax benefits are benefits you reap in the here and now, and Roth 401(k) tax benefits are benefits you reap post-retirement when you start dipping into your retirement savings.
We don’t blame you if this seems confusing. A good rule of thumb for understanding taxes on 401(k) withdrawals and contributions is that whatever goes on with a traditional 401(k), a Roth 401(k) is usually the opposite.
Calculating Tax Deductions for Traditional 401(k) Contributions
Let’s take a look at an example of how contributions to a traditional 401(k) reduces your income tax liability. If you make $60,000 annually and contribute $5,000 to your a 401(k) this year, it will reduce your taxable income by that amount, bringing it down to $55,000. In effect, contributing to your 401k will reduce your taxes owed this year by $1,250 ($5000 x 0.25).
So contributing to your 401(k) will save you money in taxes now, but when you draw from your 401(k) at retirement, you’ll pay taxes on it at your normal taxable rate at that time. The hope is that you’ll be in a lower tax bracket when you retire because you won’t need to draw as much income to live.
At what age is 401(k) withdrawal tax-free?
Generally, people don’t start withdrawing from their 401(k) until they retire, and while some people do manage to achieve financial independence and retire extremely early in life, for most people, that isn’t until they hit their 60s. The official retirement age ranges from 65 to 67 depending on when you were born. You can start receiving Social Security retirement benefits as early as 62.
For taxes on 401(k) accounts, though, there’s another important age to keep in mind: 59½. For traditional 401(k) withdrawals, you will always be paying income tax—however, once you’re six months past your 59th birthday, you can withdraw funds from your 401(k) without getting hit by early withdrawal penalties.
Likewise, 59½ is the earliest you can withdraw from a Roth 401(k) without incurring penalties, as long as your account has been open for at least 5 years. However, you can qualify for earlier tax-free withdrawals under certain circumstances, such as if you become disabled.
In short, withdrawals from a traditional 401(k) are never tax-free but are penalty-free after age 59½; for a Roth 401(k), withdrawals are tax-free if the account has been open for at least five years and the account holder is at least 59½ years old.
How to Calculate Taxes on 401(k) Withdrawals
To calculate taxes on a traditional 401(k) withdrawal in retirement, all you need to do is treat each withdrawal like a paycheck. The tax rate applied to your withdrawal will be based on your total taxable income for the year.
Let’s say you withdraw $10,000 from your 401(k) account. Georgia will likely have a flat income tax by the time you have to start withdrawing, so the state taxes on 401(k) withdrawals will be 4.99%. Federal income tax applies as well, and withdrawals are taxed at ordinary income rates. That means the federal income tax applied to your 401(k) withdrawal will depend on your tax bracket. If $10,000 is your yearly retirement income and you have no other income sources, for example, you would be taxed 10% as a single filer. That adds up to 14.99%, or $1,499. This is also assuming you’re over 59½ and aren’t subject to early withdrawal penalties.
As you can imagine, once you start dealing with larger numbers and additional post-retirement income streams, taxes on 401(k) withdrawals can get complicated, fast. Without clear guidance from a retirement tax professional, it can be easy to end up miscalculating taxes on 401(k) withdrawals or contributions and land in hot water with the IRS or state revenue services.
If you have tax issues stemming from complex taxes on 401(k) contributions and withdrawals, reach out to us online or at (404) 233-9800 to get help and resolve your situation..