How Is a 401K Taxed?

If you have a 401k retirement plan with your employer or take a job that provides one, it is important to know how a 401k is taxed. The tax deferment features of a 401k plan are its main advantage and you can lose much of the benefit if you do not know the rules. You also need to know your options if you leave your existing job and how to manage your 401k once you retire.

Identification

Many employers sponsor 401k plans for workers. Under the rules established by IRS, the employee chooses to have a set percentage of his pay contributed to the retirement plan, which may be matched by the employer. Contributions and earnings on investments within the 401k plan are tax-deferred. The employer selects the plan, but some allow employees the option of managing their own investments

Function

When you make a contribution to your 401k plan, it is treated as if it was an employer contribution and you pay no income tax. You still pay Social Security and Medicare taxes, however. If you leave your job, you can transfer -- or roll over -- your 401k into one with your new employer if that is an option, protecting the tax-deferred status. If your employer makes matching contributions, IRS rules require that you be fully vested after three years, or six years if you are incrementally vested. Being vested means you get to keep the employer's contribution whether you remain with the company or not.

Features

Normally if you withdraw funds from a 401k before the minimum retirement age, which is 59 1/2, you not only have to pay all taxes due, you will be assessed a substantial penalty. There are some exceptions allowed by the IRS. If you become disabled and unable to work or face severe financial hardship, you may be able to withdraw funds without penalty. In the event you die, your beneficiary must pay regular taxes due, but no penalty. If your employer terminates the plan and you liquidate the account, you must pay the regular taxes, but not a penalty. You do have the option of rolling over the 401k into an IRA to protect the tax-deferred status of your investments.

Retirement

Money in your 401k account retains its tax-deferred status until it is withdrawn. At that point it is subject to regular tax rates. You cannot claim capital gains on money earned from investments within your account. For this reason, it is very unwise to simply liquidate a 401k. The entire sum then becomes taxable within the current year, and that is likely to put you in a very high tax bracket.

Considerations

Although you cannot normally withdraw funds from a 401k without penalty, the IRS regulations allow you to borrow against the funds in your account under certain circumstances. If you have not been managing the 401k plan yourself, it's advisable to hire a financial consultant when you retire to help you manage your funds to produce good income with low risk. Finally, laws and regulations pertaining to 401k plans can change, so keep abreast of developments.

Resources

• Money Matters 101: Understanding Your 401k Plan