What Taxes Are 401k Plans Sheltered From?
A 401k plan diverts a percentage of your paycheck into an investment account as a way to save for retirement. In addition, many employers make a matching contribution, which adds to the money in the account. The account holder usually can't withdraw money from a 401k until he reaches the age of 59 1/2. Depending on when and how you access your 401k funds, the money may be sheltered from certain taxes.
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Benefits
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When you deposit part of your paycheck into a 401k, you don't pay state or federal income tax on it, the IRS states, or on any interest that your deposits accumulate. Instead, you'll pay tax when you withdraw it, by which time you may be earning less money and may be in a lower tax bracket.
Payments
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Putting money in a 401k doesn't have the slightest effect on your Medicaid, Social Security and unemployment tax payments, according to the IRS. If you make $40,000 a year and put $2,000 in a 401k, for example, you'll pay income tax on $38,000 but Social Security tax on $40,000.
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Emergency
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You can't normally withdraw money before age 59 1/2, but the IRS allows for hardship withdrawals in certain cases. For example, if you're buying your first home, paying for medical expenses or need the money to prevent your mortgage lender foreclosing, you can withdraw money if your company plan permits it. In those cases, you'll pay income tax on the money you withdraw--which could be enough to push you into a higher tax bracket--and you'll also pay a 10 percent tax penalty on the withdrawn funds.
Size
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Even if you're rich enough you don't need your paycheck, you can't shelter 100 percent of it in a 401k. The IRS sets a limit on how much you can put into the account in a given year, according to the tax firm H&R Block, and most company plans limit the percentage of your salary you can put in--typically no more than 15 percent. The IRS limit has varied over time, depending on inflation and federal tax policy.
Considerations
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One exception to paying tax on early withdrawal is when you roll over your money, transferring it from one retirement account to another. This can happen, for example, if you change jobs and want to move money from your old 401k to your new employer's system. If you make the rollover within 60 days, the IRS states, the money you transfer won't be subject to taxes; anything you keep will be taxed.
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