401(k) taxes: Everything you need to know

9 MIN READEditorial Policy

A 401(k) plan is a tax-advantaged retirement plan that can help you increase your retirement savings. However, you’ll still have to pay income tax on your 401(k) funds when you withdraw them or pay a penalty tax if you withdraw them before you turn 59 1/2. Below is a comprehensive guide to 401(k) taxes.

What Is a 401(k) Plan?

401(k) plans refer to qualified plans that allow employees to receive employer contributions amounting to a portion of their wages through their individual accounts under the plans. These plans come in several different forms, including profit-sharing, pre-ERISA money purchase pension, stock bonus, and rural cooperative plans.

If you’re saving for retirement, you’ll benefit from participating in a 401(k) plan. This type of employer-sponsored plan enables you to contribute as much as $23,000 in 2024. If you’re 50 or older, you’ll most likely be able to make a catch-up contribution of $7,500 each year. You may even make a catch-up contribution at the age of 49 if you’re turning 50 before the calendar year ends.

If your 401(k) plan permits, your employer can match the contributions you make to the plan. For instance, your employer may contribute 50 cents for every dollar you contribute. In some cases, an employer is allowed to make additional contributions for participants, including those who decide not to contribute to the 401(k) plan.

How Do 401(k) Taxes Work?

Also known as deferred wages or elective deferrals, 401(k) contributions are generally exempt from federal income tax withholding during the time of deferral. They aren’t reported as taxable income on the individual income tax returns of employees.

Under Internal Revenue Code (IRC) Section 402(g), the law imposes a limit on the amount a plan participant is allowed to defer on a pre-tax basis every year. Elective deferrals exceeding the dollar limit specified in Section 402(g) are re-characterized as post-tax contributions, so they’re considered a part of the employee’s gross income.

Tax Benefits of a 401(k) Plan

If you’re an employer, your contributions are deductible on your federal income tax return up to the limitations specified in IRC Section 404. To learn more about deduction limitations, look at Publication 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans). Investment gains and elective deferrals aren’t taxed on a current basis and enjoy tax deferral until they’re distributed.

If you’re an employee, you aren’t required to pay income taxes on your contributions since your 401(k) account is tax-deferred. Your contributions remain tax-exempt until withdrawal unless you have a Roth 401(k). Your employer withholds the contribution from your paycheck before it becomes subject to income tax. Although you don’t need to pay income taxes on your 401(k) contributions, you still have to pay Federal Insurance Contributions Act (FICA) taxes for Social Security and Medicare. These taxes are calculated based on the full amount in your paycheck, which includes your 401(k) contributions.

Additionally, you aren’t required to deduct the contributions to your 401(k) account on your tax return. At the end of the year, when your employer reports your earnings, they’ll take into account the fact that you contributed to your 401(k) account. For example, if you’re earning $50,000 a year and your contribution is $5000, only the remaining $45,000 is taxable. Since your employer will report the $45,000 on your Form W-2, you’ll double count your contribution if you deduct the $5,000 on your tax return. 

How Do You Report 401(k) on Taxes?

The employer reports 401(k) contributions on an employee’s Form W-2, Wage and Tax Statement. Although elective deferrals aren’t regarded as current income for federal tax purposes, they’re considered wages subject to Medicare, Social Security, and federal unemployment taxes. If you want to know what taxes are 401(k) contributions subject to and what taxes are 401(k) contributions exempt from, read Publication 525, Taxable and Nontaxable Income. The following are steps for reporting retirement contributions:

  • Box 1 (Wages) – Avoid including salary reduction contributions.

  • Boxes 3 and 5 (Social Security and Medicare wages) – Enter all employee pre-tax, post-tax, and designated Roth contributions.

  • Box 12 (Codes) – List the appropriate codes for the elective deferrals and designated Roth contributions made to different types of plans. Separate codes show excess elective deferrals. Refer to the Code Reference Chart in the instructions for the form.

  • Box 13 (Checkboxes) – If the employee actively participated in a retirement plan, check the box. Look at the decision chart in the instructions to make the right determination.

  • Box 14 (Other) – Show the amount of non-elective and matching contributions made to the 401(k) plan, as well as the amount of mandatory and voluntary employee post-tax contributions, not including Roth.

How 401(k) Contributions Reduce Your Taxes

Since contributions to your 401(k) plan reduce your taxable income, the taxes you need to pay for the year should be lowered by the amount contributed multiplied by your marginal tax rate, which depends on which tax bracket you belong to. The higher your income and therefore your tax bracket, the more tax savings you’ll get from contributing to a plan.

For instance, if you’re a single earner making an annual income of $206,000 a year, you’ll belong to the 35% tax bracket. If you contribute $5,000 a year to a 401(k) plan, your tax savings will be $5,000 multiplied by 35%, which is equal to $1,750.

Are There Penalty and Taxes for Early 401(k) Withdrawal?

The minimum age for withdrawing funds from a 401(k) plan is 59 1/2. If you decide to withdraw money before this age, you’ll have to pay 401(k) withdrawal taxes, which include federal and state income taxes and a 10% penalty tax on the amount withdrawn. You can calculate these taxes on a 401(k) calculator, which can be easily found online. Additionally, it’s important to note that age requirement for required minimum deposits (RMDs) increased from 70 1/2 to 72 after the implementation of the SECURE Act. Therefore, you aren’t required to take an RMD until you turn 72. 

Nevertheless, there are exceptions to the early withdrawal penalty. According to the Internal Revenue Service (IRS), you’re generally exempt from income tax or early withdrawal penalty tax if you’re experiencing financial hardship. Another exception is a withdrawal by a disabled taxpayer. The IRS has a complete list of situations where 401(k) participants are exempt from early withdrawal tax.

If you want to learn more about 401(k) taxes, don’t hesitate to get in touch with the knowledgeable and helpful experts at Human Interest.

We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment education, and integration with leading payroll providers.

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