How Is Your 401(k) Taxed When You Retire?
You’ve done the right thing by contributing to your 401(k) up to what your company would match. You've also monitored the account and made changes periodically to match market conditions. Because you’ve done the right thing with your account, you’re amassing a large balance. At some point you will begin making withdrawals or, in 401(k) speak, you will “take distributions.”
But no good deed goes unpunished, especially when the IRS gets involved. Yes, you will likely pay taxes on at least some of your distributions and if you’re not careful, the taxes could be quite high.
Taxes on a Regular 401(k)
Here’s how it works: the distributions on a regular 401(k) are taxed as ordinary income at the same income tax rate as your paycheck.
The reason for this, as with a traditional IRA, is that you contribute to a traditional 401(k) with pre-tax dollars. Your contribution reduces your income tax the year you make it, but it catches up with you when you start taking out the money later.
If you earn somewhere around $50,000 per year, you’re in the 25% tax bracket. Assuming you’re over the age of 59.5, when you take 401(k) distributions, you will pay 25% in taxes. If you earn more than $230,450 you’re in the 33% tax bracket, and if you’re a higher net-worth individual making more than $413,200, you’re paying 39.6%. These number may change each year based on inflation.
Financial planners view income tax as the worst kind of tax because it’s at least 10% higher than the long-term capital gains tax. For those in higher tax brackets, income tax rates are twice that of capital gains taxes. For more, see How do you withdraw money from your 401(k) ?
What About a Roth 401(k)?
Just as with the Roth IRA, the money you contribute to a Roth 401(k) is taxed before your contribution. Since you paid taxes already, you don’t have to pay them again once you take distributions. You also don’t have to pay taxes
on the earnings. In other words, with a Roth IRA, you will probably pay zero taxes on the money you contributed if you meet the income requirements .
But there are some things to consider. If your employer matches your contributions, that part of the money is considered pre-tax. You will pay taxes on those contributions when you take distributions. But unlike the traditional 401(k) you can take distributions of your contributions at any time without penalty. The earnings, however, still fall under the traditional 401(k) rules. For more information, see What are the Roth 401(k) withdrawal rules?
Talk to a Wealth Manager
Sometimes it’s best to go to the experts. In the case of your retirement funds, an expert could be helpful. For example, Christopher Cannon, M.S. CFP®, of RetireRight Pittsburgh, says, “Employer stock held in the 401(k) can be eligible for net unrealized appreciation treatment. What this means is the growth of the stock above the basis is treated to capital gain rates, not [as] ordinary income. This can be a huge tax savings. Too many participants and advisers miss this when distributing the money or rolling over the 401(k) to an IRA.”
There are other little-known strategies that could lower your tax burden that a tax professional or financial planner could help you find. Consider a fee-only adviser to help you make tax-efficient plans.
The Bottom Line
Whether a Roth or traditional 401(k) is your best bet depends on a lot of individual factors. Some professionals advise holding both a Roth and a traditional retirement account in order to minimize the risk of paying all taxes now or all taxes later. Despite articles that say one is better than the other, factors such as age, income, tax bracket and domestic status are variables to consider. Unless you have a high level of knowledge in financial planning, it’s best to get help.
To read up on the issue, see 401(k) Plans: Roth Or Regular? and When is a Roth 401(k) better than a traditional 401(k)?Source: www.investopedia.com