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401Kafe
Taxes - Frequently
Asked Questions |
Do I have to pay taxes on the money I contribute to a 401(k) plan?
Your pre-tax 401(k)
contributions are deducted from your pay before federal income taxes are withheld. You
don't pay federal taxes on this money until you withdraw it from your 401(k) account.
However, you are required to pay Social Security tax on all 401(k) contributions.
As for state income tax, most states exempt 401(k) contributions from taxation, but
depending on where you live your contributions may be subject to local income taxes.
You should check with your
company's Human Resources or Benefits representative regarding the laws in your area.
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What
are the tax advantages of participating in a 401(k) plan?
There are three primary tax advantages to participating in a 401(k) plan. They include:
Lower Income Taxes
Because your 401(k) contribution is deducted before taxes are taken out, you're be taxed
on a smaller sum of money, which makes your initial tax hit lower. An example: if you earn
$30,000 per year and are in the 28% tax bracket, your federal tax liability for the year
is $8,400. Under that same scenario, if you contribute 10% of your salary ($3,000) to a
401(k), your taxable income is decreased to $27,000. At a 28% tax rate, your federal
income tax liability will be $7,560 – that is $840 less than you'd pay if you didn't
contribute to a 401(k).
Increased Investing Power
Pre-tax investing increases your investing power by enabling you to save more. In the
example above, a 10% 401(k) contribution from a $30,000 salary is $3,000 per year. Ten
percent of your after-tax income, on the other hand, comes to less than $2,200.
Contributing before taxes enables you to save an extra $800 per month.
Tax-Deferred Compounding
Since you don't pay taxes on your 401(k) contributions or subsequent earnings until you
withdraw money at retirement, your savings accumulate faster. Say you contribute $2,000
per year to your 401(k) for 40 years, and your investment earns an annual return of 10%
each year. At the end of the 40 years, you will have contributed $80,000 to your 401(k),
but your account will be worth $973,684 – thanks greatly to the power of tax-deferred
compounding.
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Will
my Social Security benefits be affected by my 401(k) plan distributions?
Not necessarily. Having a 401(k) will not reduce your Social Security benefits – but
distributions from your 401(k) taken during retirement may make your Social Security
benefits subject to federal income tax, especially if you have significant other income.
If you are concerned that retirement savings distributions might affect your Social
Security benefits (or the taxation of those benefits) you should consult with your tax
advisor, attorney, or CPA regarding your own unique situation.
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Will
I have to pay taxes on my 401(k) plan if I leave my company?
That depends on what you decide to do with your 401(k) money. You have several options:
A. If your vested account balance is $5,000 or more and you're under age 65, you can leave
your money in your company’s 401(k) plan even when you no longer work there –
and taxes won't be due until you withdraw money from the plan.
B. You can roll over your 401(k) into a rollover IRA account or into your new employer's
401(k) plan. If you do a direct rollover – have the money transferred directly into
the new account – you won't owe taxes until you withdraw money from the account.
C. You can elect to take your money out of the 401(k) and not roll it over into a rollover
IRA or another 401(k) plan. In this case, you will owe all applicable taxes plus the 10%
early withdrawal penalty (if you are under age 59 ½) on your income tax for that year.
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Can
I make after-tax contributions to my 401(k) plan?
You can, but it may not be the most advisable course of action. Take a look at the
following comparison between pre- and post-tax 401(k) contributions. Pre-Tax
Contributions:
- Both the contributions you
make to your account and the investment gain continue to grow tax-free until you withdraw
money from your account at retirement.
- As you take money out of your 401(k), you pay taxes only on the amount you withdraw (so
that at retirement, taxes don't come due on your entire account balance at once).
- Because your 401(k) contribution is deducted from your compensation before taxes are
calculated, your taxable income is lower, so you pay less income tax.
- If you withdraw money from your 401(k) account before age 59, you will generally have to
pay a penalty (except in cases of a qualified financial hardship as defined by the IRS).
Post-Tax Contributions:
- Because post-tax contributions are made with money you've already paid taxes on, only
the investment's gain or income (i.e. interest and dividends) - and not your contributions
- enjoy the benefit of tax-deferred growth.
- When you withdraw post-tax 401(k) funds you only pay taxes on the gain (interest or
dividends) your investment has earned. As with pre-tax contributions, taxes are due only
when you take money out of your account.
- Post-tax contributions are not tax-deductible, so you don't get a tax break for making
them.
- Depending on your plan's rules, you may be able to withdraw your post-tax contributions
at any time without incurring a penalty. However, because the gain you earn on your
post-tax 401(k) investment is tax-deferred, you must pay income tax on that amount when
you withdraw your money. The gain is also subject to an early withdrawal penalty if
withdrawn before age 59 _ (except in cases of a qualified financial hardship as defined by
the IRS).
Now, considering that the best tax break and the greatest opportunity for taking
advantage of tax-deferred compounding come with pre-tax 401(k) contributions, why would
anyone consider making post-tax contributions? Here are some possible scenarios:
- If you are already making the maximum pre-tax 401(k) contribution allowed and really
want to contribute more (to get the benefit of tax-deferred investment growth).
- If your employer matches both pre-tax and post-tax contributions, and you are fully
vested for matching contributions, you might choose to maximize the employer match by
making the maximum allowable pre-tax contribution and making post-tax contributions as
well.
- If you are committed to saving money, but aren't sure you'll be able to leave your money
invested until retirement, you might make after-tax contributions because you will be able
to withdraw them without penalty before age 59 1/2. A person considering this idea needs
to remember that the gain earned on the investment is subject to an early withdrawal
penalty if taken out before age 59 1/2. Also, income tax on the investment gain is due at
the time of withdrawal.
The 401(k) is an investment vehicle for retirement. If retirement is not the goal,
there is probably a more appropriate vehicle for post-tax investment dollars.
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