401(k) Contributions Are Made Pre-Tax. So When Does the IRS Get Its Cut?

When you invest for retirement, you have a few options. You can put money into a 401(k) at work, or you can put money into a retirement plan you open yourself, such as an IRA at a brokerage firm. 

For many people, contributing to several different kinds of retirement accounts can make sense. But if you have a 401(k), it's often smart to first contribute the amount needed to max out any matching funds your employer provides. This is free money that helps you grow your account balance. 

As you contribute to your workplace 401(k), you'll notice that you get a tax break for the money you're putting in. The government wants to encourage retirement savings. In the year you make your contributions, you are not taxed on the money you're putting into the retirement plan. This can provide significant savings. But does the IRS eventually end up getting a cut of the money? Here's what you need to know. 

Here's when the IRS gets to tax your 401(k) funds

The IRS does eventually get to take a cut of the money you put into your 401(k). Here's why. 

When you invest in a 401(k) or a traditional IRA, the assumption is that you will take money out to fund your retirement. When you make a withdrawal or distribution of your 401(k) funds into your checking account, you are taxed on the distribution. You will pay taxes at your ordinary income tax rate.

The IRS wants to make absolutely sure it gets its cut, though. So if you don't want to take money out of your 401(k) because you need it for retirement, the IRS forces you to make withdrawals anyway. The IRS does this by mandating you take required minimum distributions (RMDs) from your 401(k) or traditional IRA.

These distributions must start at age 72 or age of 73 if you won't turn 72 until after Dec. 31, 2022. The IRS has tables you can use to calculate the amount you must withdraw and you have to do this or you will be hit with a penalty. This penalty used to be equal to 50% of the amount you should have taken out, but SECURE 2.0 (legislation passed in 2022) drops it to 25% or possibly 10% if you make a correction to the RMD within two years. 

If you take money out of your 401(k) early before retirement, you're also subject to a 10% tax penalty. And if you pass away, funds must be distributed to beneficiaries on a set schedule and are taxed at that time. 

Make sure you're ready for a tax bill

If you are contributing to a 401(k), it's important to understand that you are going to have to withdraw this money as a senior and pay taxes on it then. When you estimate the money available to you in retirement, remember, you'll be losing some of your funds to the government. 

If you don't want to find yourself hit with income tax on retirement account distributions in retirement, the other option available is to contribute to a Roth IRA or Roth 401(k) if your employer offers one. These don't provide a tax break when you contribute, but you can make tax-free withdrawals. So if you'd prefer not to pay taxes as a senior, these accounts could be a better bet. You also don't have to take required minimum distributions on Roth IRAs and, in the future, won't have to take them on Roth 401(k)s either thanks to SECURE 2.0. 

Consider whether your tax bracket is likely to be higher now or as a retiree so you can make an informed choice about whether to get your tax break now with a traditional account or defer it until retirement with a Roth instead.