Key Takeaways
One of the most common questions about 401(k) plans and taxes is, “Is my 401(k) tax-deductible?"
Generally speaking, you can claim deductions for 401(k) contributions—and if you haven’t made any withdrawals from your 401(k), you don’t need to report anything to the IRS
Below, we'll review different tax scenarios for 401(k) plan holders and action items for each of them
To paraphrase Benjamin Franklin, taxes are among the great certainties in life. While paying taxes on income is an annual occurrence, that doesn’t make it any less confounding. So to help reduce stress, we’re here to answer questions you may have about your 401(k) plan and taxes.
As you’re gathering your tax forms for this year, you’ll most likely run into a W-2 for income from an employer or a 1099-INT for interest income from a bank, brokerage firm, or financial institution. You will also need to take into account your 401(k) taxes and 401(k) tax deductions.
One of the most common questions about 401(k) plans and taxes is, “Is my 401(k) tax-deductible?” or, more to the point, “Do you pay taxes on 401(k) plans?”
Generally speaking, you can claim deductions for 401(k) contributions. Since one of the immediate tax advantages of owning a 401(k) is the 401(k) deductions, you may be wondering what 401(k) tax form you’ll need to attach to your return and how to report any 401(k)-related numbers on your 1040.
Let’s review different scenarios for 401(k) plan holders and action items for each of them.
Case 1 (the most common): No distributions (withdrawals) from a 401(k)
Here’s some great news for the bulk of retirement savers: if you haven’t made any withdrawals from your 401(k), you don’t need to report anything to the IRS. This means you don’t need a special form from your 401(k) provider. It also means you don’t have to pay taxes on money that stayed in your 401(k) plan that year. This is an incentive from the U.S. government to keep your contributions untouched until retirement age.
Can you deduct your 401(k) contributions?
Generally, yes, you can deduct 401(k) contributions. Per IRS guidelines, your employer doesn’t include your pre-tax contributions in your taxable income because your 401(k) contributions are tax-deductible. Instead, they report your contributions in boxes 1 and 12, respectively, of your form W-2. While contributions aren’t subject to federal withholding, they’re subject to withholding for Social Security and Medicare taxes. In the case of a Roth 401(k), you contribute with after-tax dollars. So, your employer would include your contributions in box 1 from your W-2.
Whether you own a traditional or Roth 401(k), as long as you didn’t take out any distributions, you don’t have to do a thing on your federal or state return!
Note about potential state tax forms: As more and more states are rolling out their state-sponsored retirement savings plans, you may have to do some kind of paperwork with your state government in future years. While you may opt-out from these state retirement plans due to personal choice or existing ownership of an employer-sponsored 401(k), you may have to notify your State Treasury in some way. Keep up with the latest developments in your state.
Case 2: You separated from an employer
You may have separated from your employer because you were laid off, let go, or quit. Depending on the rules and features of the employer-sponsored retirement plan from your previous employer, you may have left your contributions untouched, cashed out your account, or completed a direct or indirect rollover. Depending on the option you selected, you may be paying penalties or taxes on the 401(k) withdrawal, and your 401(k) is taxable income.
Here are the reporting repercussions for each one of these scenarios:
Case 2a: You left contributions in the plan from the previous employer.
If this is the case, you have nothing to report to the IRS, just like in the first case that we reviewed above. You’ll pay your 401(k) taxes at retirement, not before.
However, separated plan participants with vested balances under $7,000 are subject to the plan’s force out provisions, if applicable. According to a Plan Sponsor Council of America survey of 613 plans with 8 million participants, 57% of 401(k) plans with balances between $1,000 and $7,000 are forcefully transferred to an IRA of the plan’s choosing when the owner of the 401(k) doesn’t indicate what to do after separation from employment. This may not impact your 401(k) tax documents, but it will impact your investments.
If you are in this scenario, consider rolling your 401(k) funds into your new employer’s plan or an IRA of your choice. Otherwise, your funds could be rolled to an IRA provider of your former employer’s choosing.
Case 2b: You (or your employer) cashed out your 401(k)
The same survey indicates that over half of employers cash out employee accounts with balances under $1,000. Or you may have decided to cash out some or all of your nest egg. Unless you were to roll over those monies to a new account (more on that in just a bit), you would receive a 1099-R from your employer (as long as your balance was at least $10). Now, you may have a new tax bill for 401(k) contributions because it’s no longer in a 401(k). In this circ*mstance, your 401(k) tax rate is your income tax rate.
Your employer would indicate the taxable amount from your gross distribution on box 2a, and generally withhold 20% of your cash out in federal taxes on box 4 of Form 1099-R. Some states also require state withholding on 401(k) withdrawals.. 401(k) contribution deductions don’t apply if you cash out your account, and you may also owe penalties for early withdrawal if you are under age 59 1/2.
You would use your 1099-R to calculate your taxable income and report your withheld federal taxes in the appropriate places of your 1040. Individuals under age 59 1/2 need to use part one of form 5329 to calculate the applicable extra 10% in early distribution tax. Roth 401(k) holders under age 59 1/2 are also subject to the 10% tax when taking distributions. But if you’re over 59 1/2 years old, you can make withdrawals without incurring the early withdrawal penalty.
Case 2c: You completed a direct rollover
If you completed a direct rollover (monies were directly transferred from your previous plan to your new plan) for the full amount of your 401(k), then you don’t have to do anything at all. You’ll still receive a 1099-R from your previous employer, but the form will indicate that your gross distribution isn’t subject to taxes by reporting a taxable amount of $0. If you left a portion out of the rollover and kept it as cash, then you’ll have to pay applicable taxes on that portion.
Do you report your 401(k) on your taxes if you rolled it over? When the rollover is to an IRA, then the plan admin of the IRA needs to provide you a form 5498 as proof that your monies were used to fund an IRA and aren’t subject to taxes. Your 401(k) income tax is $0.
Case 2d: You completed an indirect rollover
In an indirect rollover, you received a cash distribution from your previous plan but were able to find a new qualifying plan within 60 days. In this case, the IRS will use your 1099-R from your previous employer and the W-2 from your new employer (or form 5498 from your new IRA) to cross-reference the indirect rollover on your 1040. You would report your 401(k) on your taxes, but you won’t pay a 401(k) contribution tax.
When doing an indirect rollover, you have two options. Let’s go over them, assuming that your employer cashed out a $1,000 balance from your 401(k).
You decide to roll over the $800, but not the mandatory $200 (20%) withheld by your employer: You’ll claim the $800 as non-taxable income and the $200 as taxes paid. If you were under age 59 1/2, you would need to file form 5329 to calculate the early distribution tax of 10% on the $200, unless you’re eligible for an exception.
You choose to roll over the entire $1,000 balance:Since your employer withheld $200, you’ll need to come up out of your own pocket with the $200 to fully fund a non-taxable rollover of $1,000. You’ll claim $1,000 as non-taxable income and the $200 as taxes paid.
Depending on your unique situation, you may need to file additional forms. It’s a best practice to keep records of all communications with your previous and current plan admins as evidence of a rollover. Consult your tax planner or accountant for more details on how to report your direct or indirect rollover. Here are additional resources on completing rollovers:
How to roll over your 401(k)
Should I roll over my 401(k) into an IRA?
Case 3: You have an outstanding 401(k) loan
There are many reasons why it doesn’t make sense to take a loan from your 401(k). Here’s one more: You can’t deduct the interest payments that you make on your 401(k) loan. This means you won’t receive an interest statement like the one you receive when paying mortgage interest (Form 1098).
As long as you keep up with your agreed payment schedule and you pay your loan in full within five years (or within 60 days when separating from your employer), you won’t have to do anything special on your taxes. However, defaulting on your loan turns the remaining unpaid balance into a taxable distribution and triggers the same rules described under case 2b above. Even worse, you are no longer eligible to do an indirect rollover and are likely to trigger additional penalties from your plan and state government.
Case 4: You’re retired or age 73 and over
401(k) taxes after retirement get a bit more complicated. Once you’re retired or reach age 73, you’ll have to start taking required minimum distributions (RMDs) from your traditional 401(k) or Roth 401(k). In these cases, you’ll have to consult the appropriate IRS distribution worksheets to determine your RMD starting on April 1st of the year after you retire or turn age 73. (Note: The SECURE 2.0 Act changed this age from 72 to 73.)
Is your 401(k) taxed after retirement age? Yes, the deductions for 401(k) contributions let your account grow without tax obligations, but you owe taxes when you make withdrawals.
What is the tax rate on 401(k) withdrawals? Withdrawals are taxed as ordinary income. They also may incur penalty taxes if you don’t make withdrawals on time. It’s very important that you meet your RMDs because you would owe a 25% federal penalty tax (which can be further reduced to 10%) on the difference between the amount you withdrew and the amount of your calculated minimum required distribution. To report that penalty tax, use form 5329 as part of your 401(k) tax return process.
One way to avoid having to take RMDs once you reach age 73 is to complete a rollover (as described in case 2c above) from your previous 401(k) to a new employer-sponsored 401(k) and continue working, even on a part-time basis. If you’re trying to complete this late rollover option, you can’t hold more than 5% of the company sponsoring the original traditional or Roth 401(k).
Age 73 isn’t the only age to think about retirement, here’s a list of other Critical Milestones and Ages on Your Path to Retirement.
The bottom line
As a general rule, most 401(k) retirement savers don’t have to do anything special on their taxes, and most retired 401(k) plan holders have to do something for their taxes. However, defaulting on your 401(k) loan, cashing out some or all of your balance, and completing a partial rollover will require you to do some legwork on your return. When doing any of these, make sure to get your ducks in a row and prevent an IRS penalty.
One quick way to know if you have triggered any forms that you require for your return is to check the tax statement section of the online portal of your 401(k) throughout the first quarter of every year.
