To encourage saving for retirement, the federal government offers a number of tax breaks for using 401(k) plans. These accounts generally are offered through your employer, though you can also create one for yourself if you're self-employed. Contributions to traditional 401(k) plans are excluded from your taxable income, but you can't avoid paying taxes on the money forever.
Profits in the 401(k)
One of the tax benefits of using a 401(k) for your retirement savings, according to the Internal Revenue Service, is that you won't pay taxes on any of the growth within the account. For example, if you own shares in your 401(k) plan that pay you a dividend each year, that would usually count as taxable income. But, because the gain remains in your 401(k) plan, it doesn't count as taxable income.
Taxes on 401(k) Distributions
When you take a distribution from your 401(k) plan, IRS rules require that your financial institution withhold at least 20 percent from the withdrawal for federal income taxes. At the end of the year, you'll receive a Form 1099-R that shows how much you took out and how much was withheld for taxes so you can report it properly on your return. If you've had too much withheld, you'll receive a refund of the excess. But, if you've had too little withheld, you'll have to pay the balance of what you owe when you file your return.
When you take a distribution from your 401(k) plan, you must pay the ordinary income tax rates on the distributions, which are higher than the capital gains tax rates. The IRS applies these higher rates even if your 401(k) was invested in assets that would otherwise qualify for the lower capital gains rates. For example, if you sell stocks you've held for years within your 401(k) plan and cash out the proceeds, the entire distribution is taxed at the higher ordinary tax rates.
Roth 401(k) Taxes
Roth 401(k) plans offer an alternative set-up for tax breaks. You won't receive a tax deduction for your contributions to the account, but like a traditional 401(k), the money grows tax-free in the account. Then, when you take qualified withdrawals, you won't pay any taxes on your distributions as long as you've had the account open for five years and you're at least 59 1/2 years old. For example, if you contribute $20,000 in your 20s and it grows to $100,000 by the time you're 60, you can take that entire amount without paying any ordinary or capital gains taxes on the distributions.
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