I have to pay taxes on the money I contribute to a 401(k) plan?
- What are the tax advantages
of participating in a 401(k) plan?
- What's the difference
between taxable, tax-deferred and tax-free investing?
- What are the different
kinds of tax-deferred investment vehicles?
- Will my Social Security
benefits be affected by my 401(k) plan distributions?
- Will I have to pay
taxes on my 401(k) plan if I leave my company?
- Can I make after-tax
contributions to my 401(k) plan?
1. Do I have to pay taxes on the money
I contribute to a 401(k) plan?
pre-tax 401(k) contributions are deducted from your pay before federal
income taxes are withheld. You don't pay federal taxes on this money
until you withdraw it from your 401(k) account.
you are required to pay Social Security tax on all 401(k) contributions.
for state income tax, most states exempt 401(k) contributions from taxation,
but depending on where you live your contributions may be subject to
local income taxes.
should check with your company's Human Resources or Benefits representative
regarding the laws in your area.
2. What are the tax advantages of participating
in a 401(k) plan?
are three primary tax advantages to participating in a 401(k) plan.
Income Taxes: Because your 401(k) contribution is deducted before
taxes are taken out, you're be taxed on a smaller sum of money, which
makes your initial tax hit lower. An example: if you earn $30,000
per year and are in the 28 percent tax bracket, your federal tax liability
for the year is $8,400. Under that same scenario, if you contribute
10 percent of your salary ($3,000) to a 401(k), your taxable income
is decreased to $27,000. At a 28 percent tax rate, your federal income
tax liability will be $7,560 -- that is $840 less than you'd pay if
you didn't contribute to a 401(k).
Investing Power: Pre-tax investing increases your investing power
by enabling you to save more. In the example above, a 10 percent 401(k)
contribution from a $30,000 salary is $3,000. Ten percent of your
after-tax income, on the other hand, comes to less than $2,200. Contributing
before taxes enables you to save an extra $800.
Compounding: Since you don't pay taxes on your 401(k) contributions
or subsequent earnings until you withdraw money at retirement, your
savings accumulate faster. Say you contribute $2,000 per year to your
401(k) for 40 years, and your investment earns an annual return of
8 percent each year. At the end of the 40 years, you will have contributed
$80,000 to your 401(k), but your account will be worth $518,113 --
thanks greatly to the power of tax-deferred compounding.
3. What's the difference between taxable,
tax-deferred and tax-free investing?
taxable investment is one in which you pay taxes every year on the dividends
and appreciation of investments that you sell. A simple example of a
taxable investment is a regular savings account. Every year when you
file your tax return, you're required to report the interest your savings
account has earned and pay taxes on it. Here's a good rule of thumb:
any time you buy a stock, bond, mutual fund, money market account, etc.,
that is not part of a special tax-sheltered account (such as a 401(k),
403(b), IRA, etc.) it is most likely a taxable investment, and you'll
be required to pay taxes on its earnings every year.
tax-deferred investment is one in which you do not have to pay taxes
on the investment's earnings until you withdraw money from the account.
Examples of tax-deferred investments include 401(k), 403(b), and IRA
accounts. In many cases, contributions you make to tax-deferred accounts
are partially, if not completely, tax deductible. Because tax-deferred
accounts are designed to help people save for specific goals -- such
as retirement or a child's education -- there are hefty penalties attached
to withdrawing your money from the account too soon.
tax-free (or tax-exempt) investment is one in which you don't have to
pay taxes on the income the investment earns. A municipal bond is an
example of a tax-free investment. Note however, that just because an
investment is called "tax-free" does not mean that you won't have to
pay any taxes on it. Some tax-free investments are exempt from only
federal income taxes, while others may be exempt from only state or
is one investment that is both tax-deferred and tax-free, the Roth IRA.
You contribute after-tax money to this individual savings account, but
your money grows tax-deferred and you don't pay income tax on the money
(not even the earnings) when you withdraw it.
4. What are the different kinds of tax-deferred
tax laws in recent years have increased the number of tax-deferred retirement
accounts available. Because of the various rules governing eligibility,
you should consult a professional tax advisor when deciding which of
the following options best suits your situation.
-- You may make pretax contributions of up to $11,000 in 2002, and
your employer may contribute additional matching funds. You earn compound
interest. Applicable taxes must be paid when money is withdrawn, and
there is a 10 percent penalty for early withdrawal (before 59ý, or
55 if you leave your job).
IRA -- You may contribute up to $3,000 in 2002. Whether these
contributions are tax deductible depends on whether you participate
in a 401(k) and what your income level is. You earn compound interest
on the money in the account. Applicable taxes are due when money is
withdrawn, and there is generally a 10 percent penalty for early withdrawal
(before 59ý) of pre-tax contributions and the account's earnings.
IRA -- You may contribute up to $3,000 in 2002. Contributions
are not deductible, but interest grows tax-free and you pay no tax
upon withdrawal. If your gross income is over $160,000 for joint filers
or $110,000 for single filers you may not contribute to a Roth IRA.
IRA -- If you do not have earned income but your spouse does,
you may contribute up to $3,000 to a spousal IRA in 2002, even if
your spouse is covered by a 401(k) plan at work. Whether contributions
are tax-deductible depends on income level and participation in an
IRA -- A SIMPLE IRA works a lot like a traditional IRA except
that you can contribute more (up to $7,000 in 2002) and employer matching
contributions are allowed. A self-employed person can contribute $7,000
as an individual, and his company can match his contributions dollar-for-dollar,
for a total annual contribution of $14,000. Another plus, the SIMPLE
plan you set up now can grow with your company. Employers with 100
or fewer employees can use this plan.
401(k) -- A SIMPLE 401(k), a variant of the SIMPLE IRA, works
much like the SIMPLE IRA with a few notable exceptions. On the downside,
it requires a lot more reporting and administration than a SIMPLE
IRA does. On the upside, a SIMPLE 401(k) allows for hardship withdrawals
and loans. A SIMPLE 401(k) can be set up for companies with 100 or
fewer employees. The maximum salary deferral allowed per employee
in 2002 is $7,000 or a percentage of salary specified by the employer,
whichever is less. The employer must make either dollar-for-dollar
matching contributions up to 3 percent of compensation for each employee
(for a total employer and employee contribution of up to $14,000),
or non-elective contributions of 2 percent of compensation on behalf
of each eligible employee who receives $5,000 or more in compensation
from the employer.
Employee Pension IRA (SEP-IRA) Plans -- SEP plans are essentially
individual retirement accounts (IRAs). The money you contribute to
a SEP-IRA is tax-deductible and your investment earnings grow tax-free
until you withdraw funds at retirement. For 2002, if you are the only
participant in the plan, you can deduct contributions of up to 25
percent of your compensation or $40,000, whichever is less. If you
have employees, in 2002, they may contribute up to 100 percent of
their compensation or $40,000, whichever is less.
Plans -- If your business is not incorporated, you may be eligible
to establish a Keogh plan. Keogh plans are generally more flexible
than SEPs and may allow you to save even more toward your retirement
than you can in a SEP plan. For 2002, you can save up to $40,000 a
year in combined employer and employee contributions in a Keogh. Keogh
plans must be set up as either a defined-contribution plan [like a
401(k) or SEP] or as a defined-benefit plan (like a traditional pension).
In other words, you will need to have a plan document. For that reason
if you're considering a Keogh plan, you may want to seek the advice
of a pension professional.
plans -- These are similar to 401(k) plans, and are sometimes
referred to as "401(k)s for non-profits" because they are commonly
used by non-profit institutions like hospitals, public school systems
and charitable organizations. Many of the rules governing 403(b) plans
are similar to those for 401(k) plans. These plans offer a choice
of investment options, often permit loans and may have an employer
matching contribution. For 2002, the maximum annual contribution to
a 403(b) plan is $11,000.
plans -- A tax-deferred savings plan offered to employees of state
and local governments. (A different type of 457, the 457(f) is sometimes
offered to top-level management in tax-exempt organizations and has
different rules.) The maximum contribution to a 457(b) in 2002 is
$11,000 (unlike 401(k) plans, this limit includes both employer and
employee contributions). The limit in 2001 was $8,500. Some 457 participants
are eligible to make additional "catch-up" contributions when they
are within three years of retirement.
5. Will my Social Security benefits be
affected by my 401(k) plan distributions?
necessarily. Having a 401(k) will not reduce your Social Security benefits,
but distributions from your 401(k) taken during retirement may make
your Social Security benefits subject to federal income tax, especially
if you have significant other income.
you are concerned that retirement savings distributions might affect
your Social Security benefits (or the taxation of those benefits) you
should consult with your tax advisor, attorney, or CPA regarding your
own unique situation.
6. Will I have to pay taxes on my 401(k)
plan if I leave my company?
depends on what you decide to do with your 401(k) money. You have several
the money: If your vested account balance is $5,000 or more and
you're under the plan's normal retirement age, which is commonly age
65, you can leave your money where it is -- and taxes won't be due
until you withdraw money from the account. However, if your balance
is less than $5,000 and more than $1,000, your employer may decide
to automatically roll it into an IRA account on your behalf. If this
occurs, there are no tax consequences because the money is moving
from one tax-deferred account to another.
the money into a new plan or IRA: You can roll over your 401(k)
into a rollover IRA account or into your new employer's 401(k) plan.
If you do a direct rollover -- have the money transferred directly
into the new account -- you won't owe taxes until you withdraw money
from the account.
out: If you elect to take your money out of the 401(k) and not
roll it over into a rollover IRA or another employer-sponsored retirement
plan you will owe all applicable taxes. You will also owe a 10 percent
early withdrawal penalty unless you leave your company during the
year you turn 55 or later.
7. Can I make after-tax contributions to
my 401(k) plan?
can, but it may not be the most advisable course of action. Take a look
at the following comparison between pre- and post-tax 401(k) contributions.
By the way, not all employers permit after-tax contributions to their
401(k) plan. Check your Summary Plan Description to find out
if after-tax contributions are allowed.
the contributions you make to your account and the investment gain continue
to grow tax-free until you withdraw money from your account at retirement.
you take money out of your 401(k), you pay taxes only on the amount
you withdraw (so that at retirement, taxes don't come due on your entire
account balance at once).
your 401(k) contribution is deducted from your compensation before taxes
are calculated, your taxable income is lower, so you pay less income
you withdraw money from your 401(k) account before age 59ý you will
generally have to pay a penalty. The penalty will not apply in the cases
of a qualified hardship as defined by the IRS, if you take early retirement
starting in the year you turn 55, or if prior to turning 55, you take
withdrawals based on a series of equal periodic payments as defined
by the IRS.
post-tax contributions are made with money you've already paid taxes
on, only the investment's gain or income (i.e. interest and dividends)
-- and not your contributions -- enjoy the benefit of tax-deferred growth.
you withdraw post-tax 401(k) funds you only pay taxes on the gain (interest
or dividends) your investment has earned. As with pre-tax contributions,
taxes are due only when you take money out of your account.
contributions are not tax-deductible, so you don't get a tax break for
on your plan's rules, you may be able to withdraw your post-tax contributions
at any time without incurring a penalty. However, because the gain you
earn on your post-tax 401(k) investment is tax-deferred, you must pay
income tax on that amount when you withdraw your money. The gain is
also subject to an early withdrawal penalty if withdrawn before age
59ý. The penalty will not apply in the cases of a qualified hardship
as defined by the IRS, if you take early retirement starting in the
year you turn 55, or if prior to turning 55, you take withdrawals based
on a series of equal periodic payments as defined by the IRS.
considering that the best tax break and the greatest opportunity for
taking advantage of tax-deferred compounding come with pre-tax 401(k)
contributions, why would anyone consider making post-tax contributions?
are some possible scenarios:
you are already making the maximum pre-tax 401(k) contribution allowed
and really want to contribute more (to get the benefit of tax-deferred
your employer matches both pre-tax and post-tax contributions, and
you are fully vested for matching contributions, you might choose
to maximize the employer match by making the maximum allowable pre-tax
contribution and making post-tax contributions as well.
you are committed to saving money, but aren't sure you'll be able
to leave your money invested until retirement, you might make after-tax
contributions because you will be able to withdraw them without penalty
before age 59ý. A person considering this idea needs to remember that
the gain earned on the investment is subject to an early withdrawal
penalty if taken out before age 59ý. Also, income tax on the investment
gain is due at the time of withdrawal.
401(k) is an investment vehicle for retirement. If retirement is not
the goal, there is probably a more appropriate vehicle for post-tax