Tax Season Basics | How Taxes Impact Your 401k

Whether you’re experienced with the 401K process or you are accepting your first position where a 401K plan is offered, understanding all the elements of the plan is important to properly manage your personal finances in 2022. During tax season, a hands on approach to financial management is required to properly file business or personal tax returns. How does a 401k plan impact your taxes? Keep reading to learn more!

 

Early Withdrawals

If you choose to withdraw from your 401K early, you will have to pay taxes on that money. This situation is not very common amongst 401K savers, but it’s possible that some individuals may be put in a situation where they have no other alternative and must withdraw funds early. 

 

If you are under the age of 59 1/2 when you take a distribution you will have to pay a 10% penalty – and this is separate from the tax due. Some individuals may qualify for an exemption from this penalty, or they may be able to take the money out as a repayable 401k loan.  Reasons for exemption may include withdrawals taken to pay medical expenses and bills, the individual becoming permanently disabled and other hardships, being a first-time homebuyer (and using the funds for the home purchase), education expenses, and more.  Although the penalty may be waived, be aware that you will still be required to pay taxes on any early withdrawals. 

 

Tax-Deferred Interest

With a 401K, no income tax is taken out of the money you put into it. That is, this is a “pre-tax” retirement contribution – when your employer deducts your contribution from your paycheck to your 401K, you won’t pay any tax on that income. Keep in mind that by the time you hit 72 years of age you will be required to withdraw a minimum amount of money from your 401K each year (called an RMD), and those withdrawals will be taxed. It is also important to note that FICA taxes, Social Security and Medicare, are taken out of 401K contributions. FICA tax calculations are based on your income before the contributions. 

 

Defer Your Taxable Income

As long as you are under the age of 72 and currently employed, you do not ever have to take money out of your 401k. If you have switched employers and they have a different 401k plan, you can roll the old 401k into the current one. Remember, 401K compound interest does not get taxed like traditional savings accounts. 

 

Our Experienced Advisors

At Taurus CPAs, our mission has remained consistent since our founding – to be exceptional service providers and trusted advisors who integrate strategic advice and innovative solutions with integrity, quality, and reliability.

 

As a true business partner, we are available to help you deal with any business problem or opportunity. We stand ready to engage in business consulting projects to help you make the right decisions for the future of your business.