A 401(k) plan can be a valuable savings tool, but many retirees are surprised to learn that they'll need to start paying taxes once they begin cashing out their balances. Though 401(k) contributions are exempt from income tax, once you start taking distributions, each disbursement from your plan will be taxed at your ordinary income rate. Planning for 401(k) taxes in retirement can help you avoid getting caught off-guard at a time when you're financially vulnerable.
Enjoy the up-front tax savings
One major benefit of 401(k) plans is the initial tax savings they offer. Any money that goes into a 401(k) is contributed on a pre-tax basis, which can help lower your taxes during your working years, when your tax burden is presumably the highest.
Your ultimate tax savings for contributing to a 401(k) will depend on your effective tax rate. As an example, if your income is typically taxed at 25%, and you contribute $10,000 to a 401(k), you'll save $2,500 on taxes at present. Furthermore, if your employer offers a matching program, you won't pay taxes on whatever amount goes in along with your own contributions.
Currently, anyone under 50 can contribute up to $18,000 a year to a 401(k). If you're 50 or older, you're allowed a $6,000 catch-up for an annual total of $24,000. Maxing out these limits can not only help lower your taxes, but ensure that you have a nice foundation for your retirement savings.
Taxes on 401(k) withdrawals
While the money you contribute to a 401(k) goes in on a tax-free basis, withdrawals are a different story. Once you start cashing out your 401(k), your distributions will be taxed as ordinary income -- meaning, the rate at which your regular income is taxed. The good news for many seniors is that their ordinary income tax rate is lower in retirement than it is during their working years. The bad news, though, is that once you're retired, you won't get your withdrawals free and clear of taxes, and that's something to keep in mind as you plan for the future.
Imagine you expect to need $15,000 a year from retirement savings in addition to your estimated Social Security benefits to keep up with your expenses once you're no longer working. If you believe in the 4% rule -- which states that if you start by withdrawing 4% of your savings during your first year of retirement and adjust successive withdrawals for inflation, your savings should last 30 years -- then your goal might be to amass $375,000 in a 401(k).
But while that $375,000 should, in theory, enable you to withdraw $15,000 your first year of retirement and adjust for inflation thereafter, that $15,000 won't all end up in your pocket. You'll need to pay taxes on a portion of it, which means you'll actually have less available to use for expenses. This is something to be aware of as you get closer to retirement, as you'll want to make sure you have enough savings before making your permanent exit from the workforce.
Taxes on early withdrawals
The money in your 401(k) is there to help you fund your retirement, so withdrawing it early is generally not a good idea. That said, sometimes situations arise where people have no choice but to tap their retirement savings. Just know that if you do withdraw money from a 401(k) plan before you reach 59 1/2, your distribution will be assessed an early withdrawal penalty of 10% unless you qualify for an exception.
What counts as an exception? If you incur medical expenses that exceed 10% of your adjusted gross income, you can typically withdraw your money penalty-free. The same applies if you become permanently disabled. But even if you take an early withdrawal that qualifies for an exception to the penalty, you'll still need to pay taxes on whatever distribution you collect. Furthermore, your withdrawal will be taxed based on your ordinary income tax rate at the time -- whatever that happens to be.
While there are plenty of good reasons to open a 401(k), you should be aware that you will pay taxes on withdrawals, no matter when you take them. It just goes to show that you can't escape the IRS -- even in retirement.