So you're getting ready for retirement and wondering if you'll need to pay taxes on all those dividends you receive in your growing 401(k) account. The short answer is yes, but you don't have to pay any taxes on the dividends in the years you receive them. Dividends are a portion of a company's profit, paid out to investors in amounts based on the number of company shares they own. If something comes up and you need to withdraw the dividends or other income in your 401(k) early, you'll pay regular taxes plus an additional penalty tax. It helps to understand the rules as you strategize the best way to utilize your retirement assets to minimize taxes.
The 401(k) Account Defined
A 401(k) plan is a type of tax-deferred retirement plan that your employer sponsors. The plan allows you to put money into the account before it's taxed; you receive your paycheck minus the contributed funds each pay period. In many companies, employers also match a percentage of your contributions. For example, your employer could match 50 percent of your contributions up to a limit of 6 percent of your pay. Your money grows tax free until retirement, and once you withdraw it, you'll pay taxes on the amount of withdrawals at your then-current marginal tax rate. Your company's benefits administrator will provide you with a monthly statement so you can track your 401(k) investment activity.
Types of Dividends
Many 401(k) plans have a defined set of mutual funds in which they invest your money, and the funds may or may not pay dividends. Dividends are typically classified as qualified or unqualified; for qualified, you'd pay a lower capital gains tax rate if you had received the dividends outside of a tax-deferred account. When you receive dividends inside your 401(k), however, you lose this tax advantage and you'll pay your regular tax rate on any dividend income. When stocks within your mutual funds pay dividends, the funds typically reinvest the cash to purchase more shares for your account and you don't have a choice in the matter. If you hold individual stocks in your 401(k), you'll pay your regular tax rate on any dividends whether or not you reinvest in more shares.
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Taking Money Out of Your 401(k)
Regardless of the amount of dividend income you receive in your 401(k), you'll never pay taxes on it until you start withdrawing money from your account. Once you reach age 591/2, the IRS lets you withdraw your money without penalty; any earlier, and you'll pay a 10 percent penalty to the IRS on top of regular taxes. A 401(k) account, like all employer-sponsored tax-deferred retirement plans, requires you to take withdrawals once you retire. However, as long as you keep working for the employer who sponsors your 401(k) plan, you can put off taking distributions even if you're older than age 701/2.
Tax Form 1099-DIV Dividends and Distributions
By January 31st of each year, you'll typically receive a 1099-DIV form for any dividends received in your non-tax-deferred accounts. Since dividends paid into a 401(k) account do not have any tax effects until you withdraw the money upon retirement, you won't receive any 1099-DIV forms for this account and you also won't need to add any dividend information to your tax return for your 401(k) account.