While a 401(k) is an excellent option for saving for retirement, especially if your employer matches your contributions, it is important to understand your tax obligations on these accounts. When you retire, you will need to pay taxes on your 401(k) withdrawals.
You will not be taxed on your 401(k) when you initially make the contribution. In fact, one of the perks of a 401(k) account is the money is taken out of your paycheck before you pay taxes. This pre-tax contribution will lower your tax liability, which means you will pay the IRS less on a weekly (and annual) basis while you are working. Since many people make less money during retirement than while they were working, it makes sense to delay paying income taxes. However, you must factor in how much they will be paying in taxes so that they can save and plan accordingly.
Once you retire and begin withdrawing funds from your 401(k), you will pay income taxes on this money, whether it came from your initial contribution or the gains on your contributions. The amount you are taxed will be based on your income tax rate when you withdraw the funds. Currently, the income tax rate ranges from 10% (when an individual makes less than $9,325 per year) to 39.6% (when an individual makes over $418,400), but these percentages could change in the future.
Let’s say you withdraw $30,000 each year to supplement your social security payments after retirement. This will put you in the 15% tax bracket, which means you will pay $4,500 in income taxes each year.
If you decide to withdraw money before you reach retirement age (59 1/2), you will not only pay income taxes, you will also have to pay a 10% penalty unless you qualify for an exception, such as medical expenses that exceed 10% of your adjusted gross income or you become permanently disabled. Even if you are exempt from paying the 10% penalty, you will still need to pay income taxes for your withdrawal, which will be based on your tax bracket.
Up to this point, we have been discussing the tax liabilities of a traditional, employee-sponsored 401(k) plan. With a Roth 401(k), you make contributions to your retirement from your post-tax income. Since you have already paid income tax on the contribution, you will not need to pay taxes when you begin withdrawing money after retirement, as long as your account has been funded for at least five years. In fact, if you meet certain income requirements, you will not need to pay taxes on the contribution earnings either. However, if your employer contributes to your Roth 401(k), those contributions will be made pre-tax, which means you will have to pay income tax on that money after retirement.
Another benefit to a Roth 401(k) is that you can make early withdrawals on the amount you contributed without paying penalties or taxes. However, you will have to pay a 10% penalty and taxes on any withdrawals that arose from contribution gains.