Last Update MAY 19 2020
Are 401(k) distributions taxable? Yes. They are taxable.
The IRS allowed pre-tax personal contributions. They also allowed the gains to grow tax-deferred for years. However, there comes the point when the IRS stops being so generous and wants their tax. This happens when you start to take a distribution from the plan. If your 401(k) contributions were traditional personal deferrals, the answer is yes; you will pay income tax on your withdrawals. If you take withdrawals before reaching the age of 59 ½, the IRS may also impose a 10% penalty. CARES ACT recently passed has removed the 59 ½ 10% rule for now but not forever. We think it will be good for the year 2020 but no one knows for sure what happens after that.
What is the mandatory withdrawal from a IRA at age 70 and What happens if I do not take my RMD?
If you don’t take any distributions and reach the age of 72 ½, the IRS will step in and force you to take a distribution. They are called Required Minimum Distributions (RMDs). The new age at which RMD must start is 72 1/2 in 2020, with the deadline of April 1 of the following year. The IRS’s rationale is, “hey time to pay up – you aren’t getting any younger.” The IRS has a schedule, and they will tell you how much your minimum distribution will be. This distribution, of course, will be considered income and will add to your other income for the affected year.
RMD’s have been suspended for the year 2020 – CARES ACT
RMDs for those who turned 70 ½ in 2019 are not delayed. Such individuals must continue to take their RMDs under the same rules prior to the passage of the SECURE Act.
In the past few years, 401(k) plans have been allowed to accept Roth contributions. However, not all plans have adopted this. As long as the Roth rules have been adhered to, the distributions should be tax-free. The RMD will kick in at the age of 72 ½ even if your 401(k) is Roth. When that day arrives, you have the option of rolling the ROTH portion of the 401 k to a Roth IRA. Roth IRA’s do not follow the RMD rules. Conversely, if you are still working, and own less than 5% of the company sponsoring the plan, you can delay RMD’s
All the plans we create at Self Directed Retirement Plans LLC contain the Roth provision. Please contact us at 866 639 0066, and we can answer your questions.
401(k) taxes on contributions
Your 401(k) contributions are deducted from your paycheck much before the IRS takes its cut. For example, if your monthly paycheck is $2,000 before taxes, and you contribute $500 to your 401(k), you’ll be taxed on $1500 and not $2,000.
- If you have a Roth 401(k), unlike the traditional 401(k), your contributions are made with after-tax money. Although Roth 401(k) has a few advantages, you still need to pay Social Security taxes and Medicare on your paycheck contributions to a 401(k).
- For 2019, you can contribute up to $19,000 to a 401(k) plan. If you are age 50 and older, you can contribute up to $26,000.
- The 401(k) contributions limit for 2020 is $19,500. This means you can shield $19,000 a year from income taxes. If you are age 50 and above, your contribution limit is $26,000 in 2020.
- The annual contribution limit is per individual and is applicable to the total contributions you make into your traditional or Roth 401(k).
- In January, your employer sends a W-2, which includes details of how much it paid you in the previous calendar month, how much you have contributed to your 401(k) and how much withholding tax you have paid.
401(k) taxes when your money is in the account
When your money is in a traditional 401(k) or a Roth 401(k), you are not liable to pay any taxes on interest, dividends, and investment gains.
401(k) taxes when you make withdrawals
In a traditional 401(k), your contributions and your investment growth are tax-deferred. However, you have to pay taxes when you start making withdrawals from the account. In the case of a Roth 401(k), since you already pay taxes upfront while making the contributions, you don’t owe any taxes when you withdraw from the account.
401(k) taxes if you withdraw the money in retirement
- Taxes on a Regular 401(k): The contributions you make to a regular 401(k) plan are tax-deferred. Therefore, you need to pay taxes when you start taking the distributions.
- Taxes on a Traditional 401(k): Since you don’t pay income taxes when you make contributions to a traditional 401(k)s, the taxes are applicable when you start withdrawing money from the account.
- Taxes on a Roth 401(k): For Roth 401(k)s, you pay income tax when you make contributions, but your withdrawals are not taxable.
- Roll Over Funds: If you carry out a direct rollover from your retirement account to another retirement plan or your spouse’s plan, no additional taxes are incurred. But, if you carry out an indirect transfer (distributing funds to the account holder and not from one institution to another), you are liable to pay income tax. However, if you deposit this fund to another Roth 401(k) or Roth IRA within 60 days, you can avoid taxation.
401(k) taxes if you withdraw the money early
If you make an early withdrawal or pull out money from your traditional 401(k) before you turn 59½, you have to face these three consequences:
- The IRS will withhold 20% of your early withdrawal amount. For example, if you make an early withdrawal of $10,000 at age 40 from your 401(k), you will get about $8,000. The rest of the amount will be withheld for taxes.
- The IRS will penalize you with a 10% penalty on the withdrawal amount when you file your tax return. This means you’ll be giving up yet another $1,000 to the government for that $10,000 withdrawal. CARES ACT waives the 10% for the year 2020.
- Early withdrawal depletes your retirement savings. This can have long-term consequences, especially when the market is down, and you need to start making withdrawals.
Tips to minimize 401(k) taxes
- Withdrawals trigger taxes; so, procrastinate your withdrawals for as long as you can.
- If you have to make an early withdrawal from a 401(k), check if you qualify for an exception to avoid paying the penalty.
- Be cautious about how you carry out a rollover. Rollover of funds from an old 401(k) into another 401(k) or into an IRA usually don’t attract taxes, if you manage to get the money into your new account within 60 days. Or else, the IRS considers this move as a contribution that is taxable and has to be penalized.
- Check if you are eligible for the Saver’s Credit on your contributions.
- Consider tax-loss harvesting. Sell underperforming securities in your regular investment account at a loss. The loss on the securities offsets some or all of the taxes on your 401(k) withdrawal.
- Borrow instead of withdrawing from your 401(k). Some plans allow you to take a loan from your 401(k), which you need to repay within 5 years by making regular payments. Check with your plan administrator if you are eligible for a loan.
- Consult a tax professional. A qualified tax professional will discuss your options to minimize your 401(k) taxes.
All the plans we create at Self Directed Retirement Plans LLC contain the ROTH provision. Please contact us at 866 639 0066 and we can answer your questions.