Paying Tax Later Doesn't Always Mean Paying Less

How 401(k)s are taxed

One of the most important things to remember about your 401(k) is this: The balance you see isn’t how much you’ll have available for retirement. The reason? Taxes.

Tax breaks on contributions

As a retirement plan, 401(k)s are popular because they are tax-advantaged in the short term. Your contributions during the year are excluded from your earnings and will only be taxed on withdrawal, meaning you can lower your tax bill now and not worry about it for years to come. 

Many employers offer a 401(k) match as an added benefit, too. They’ll match your actual contributions up to a pre-determined limit by putting the money into your retirement account.

Sounds good so far. But what happens in the long term, when you withdraw funds from the plan?

Taxes on withdrawals

Distribution from your 401(k) is taxed as ordinary income, like earnings from employment. Your tax bill will depend on your age and income level. While many people expect to be in a lower tax bracket by the time they retire, this doesn’t always happen, particularly as retirees typically have less deductions. 

Taking 401(k) distributions could push you into a bracket where your Social Security benefits become taxable. If your income is high enough, your monthly Medicare premiums could also go up. Unfortunately, IRS prescribes minimum distribution amounts once you reach 72 — so you’ll have limited control over how much to withdraw.

The bottom line? 401(k)s have pros and cons. There could be more tax efficient ways for you to save for retirement. Talk to your financial professional to find out more.

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