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Most 401(k) plans are tax-deferred. This means that you don’t pay taxes on the money you contribute — or on any gains, interest or dividends the plan produces — until you withdraw from the account.
That makes the 401(k) not just a way to save for retirement; it’s also a great way to lower your taxable income. But there are a few rules about 401(k) taxes to know, as well as a few strategies that can get your tax bill even lower.
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Taxes on 401(k) contributions
Contributions to traditional 401(k) plans come out of your paycheck before the IRS takes its cut. You’ll sometimes hear this referred to as “pre-tax income,” and it means two things: 1) you won’t pay income tax on those contributions, and 2) they can reduce your adjusted gross income.
An example of how this works: If you earn $50,000 before taxes and you contribute $2,000 of it to your 401(k), that's $2,000 less you'll be taxed on. When you file your tax return, you’d report $48,000 rather than $50,000.
A few other notable facts about 401(k) contributions:
In 2023, you could contribute up to $22,500 a year to a 401(k) plan. If you're 50 or older, you could contribute $30,000.
In 2024, that limit rises to $23,000. Those 50 or older can contribute up to $30,500.
The annual contribution limit is per person, and it applies to all of your 401(k) account contributions in total.
You still have to pay some FICA taxes (Medicare and Social Security) on your payroll contributions to a 401(k).
Taxes on 401(k) withdrawals
If you withdraw the money early
For traditional 401(k)s, there are three main consequences of an early withdrawal or cashing out before age 59½:
Taxes will be withheld. The IRS generally requires automatic withholding of 20% of a 401(k) early withdrawal for taxes. So if you withdraw the $10,000 in your 401(k) at age 40, you may get only about $8,000.
The IRS will penalize you. If you withdraw money from your 401(k) before you’re 59½, the IRS usually assesses a 10% penalty when you file your tax return. That could mean giving the government an additional $1,000 of that $10,000 withdrawal.
You will have less money for later, especially if the market is down when you start making withdrawals. That could have long-term consequences.
There are a lot of exceptions, but you might be able to avoid the IRS’s 10% penalty for early withdrawals from a traditional 401(k) if you:
Receive the payout over time.
Qualify for a hardship distribution with the plan administrator.
Leave your job and are over a certain age.
Are a domestic abuse survivor.
Are getting divorced.
Give birth to a child or adopt a child.
Are or become disabled.
Put the money in another retirement account.
Use the money to pay an IRS levy.
Use the money to pay certain medical expenses.
Were a disaster victim.
Overcontributed to your 401(k).
Were in the military.
Are terminally ill.
Finally, a provision in the Secure 2.0 Act, which became law at the end of 2022 and revised many of the government's rules for retirement plans, allows special emergency 401(k) distributions of up to $1,000 per year beginning in 2024. The taxpayer can pay the $1,000 back over a three-year period, and no other distributions can be made until the money is repaid.
Dive deeper: How 401(k) withdrawals and penalties work
If you withdraw the money at or after age 59½
For traditional 401(k)s, the money you withdraw (also called a “distribution”) is taxable as regular income — like income from a job — in the year you take it. (Remember, you didn’t pay income taxes on it back when you put it in the account; now it’s time to pay the IRS.) You can begin withdrawing money from your traditional 401(k) without penalty when you turn age 59½. The rate at which your distributions are taxed will depend on what federal tax bracket you fall in at the time of your qualified withdrawal.
A few important points:
If you’ve retired, you have to start taking required minimum distributions from your account when you're 73 as of 2023.
If you don’t take the required minimum distribution when you’re supposed to, the IRS can assess a penalty of 50% of the amount not distributed.
You can withdraw more than the minimum.
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Taxes on Roth 401(k) plans
Some employers offer another type of 401(k) plan called a Roth 401(k). These savings plans take the opposite approach when it comes to taxation: They’re funded by post-tax income. This means your contributions won’t lower your AGI ahead of tax-filing season.
The biggest benefit of a Roth 401(k) is that because you’re paying taxes on your contributions now, you can withdraw the contributions tax-free later. A few other important notes:
You can begin withdrawing money from your Roth 401(k) without penalty once you’ve held the account for at least five years and you’re at least 59½.
You can withdraw contributions from a Roth 401(k) early if you’ve held the account for at least five years and need the money due to disability or death.
Roth 401(k)s also require taking RMDs.
Compare Roth 401(k) vs. traditional 401(k)
Tax treatment of contributions
Contributions are made pre-tax, which reduces your current adjusted gross income.
Contributions are made after taxes, with no effect on current adjusted gross income. Employer matching dollars must go into a pre-tax account and are taxed when distributed.
Tax treatment of withdrawals
Distributions in retirement are taxed as ordinary income.
No taxes on qualified distributions in retirement.
Withdrawals of contributions and earnings are taxed. Distributions may be penalized if taken before age 59½, unless you meet one of the IRS exceptions.
Withdrawals of contributions and earnings are not taxed as long as the distribution is considered qualified by the IRS: The account has been held for five years or more and the distribution is:
Unlike a Roth IRA, you cannot withdraw contributions any time you choose.
7 ways to reduce your 401(k) taxes
Wait. Consider staying out of your 401(k) account if you can help it. Withdrawals, especially early ones, can trigger taxes.
Look for exceptions. If you must make an early withdrawal from a 401(k), see if you qualify for an exception that will help you avoid paying an early withdrawal penalty.
Consider credits. See if you qualify for the saver’s credit on your contributions.
Weigh taking a 401(k) loan vs. a withdrawal. In most circumstances, you’ll need to repay the loan within five years and make regular payments. And not all 401(k) plans offer loans. Check with your plan administrator for the rules.
Explore tax-loss harvesting. You might be able to offset the taxes on your 401(k) withdrawal by selling underperforming securities at a loss in some other regular investment account you might have. Those losses can offset some or all of the taxes on your 401(k) withdrawal.
See a tax professional. There are other ways to minimize your 401(k) taxes, too. A qualified tax pro can discuss your options with you.
» Dive deeper: View our list of the best rollover IRA providers