Employees whose employers sponsor a 401(k) retirement plan are given the opportunity to invest a considerable amount for their future. But how does it affect 401(k) tax returns?

It is necessary to learn what the withdrawal and deduction implications of your 401(k) are to ensure you maximize the full benefit of this retirement plan.

Keep reading to learn the definition of a 401(k) plan, how it is taxed, what conditions apply if you withdraw from the plan before retirement, and more!

Key Takeaways

• The 401(k) retirement savings plan is offered by employers to employees.
• Account holders younger than 50 are allowed up to $22,500 in contribution limits, while those aged 50 and above may contribute up to $30,000.
• Contributions to a 401(k) are made on a pre-tax basis. 401(k) contributions are not tax deductible.
• The Form W-2 lists all contributions made by the employee to their 401(k) retirement account. Withdrawing funds before one reaches the age of 59 ½ yields a 10% penalty.
• Contributions to a 401(k) are made after-tax, and it also requires account holders to reach at least 59.5 years of age before withdrawing the funds.

What is a 401(k) Plan?

A 401(k) plan is a type of retirement savings plan that is backed or financed by US-based companies for their employees. Employees can contribute to their plans, while employers can match the said contributions.

When it comes to contribution limits, the amount solely depends on the contributor or employee.

What makes a 401(k) ideal and stand out among other retirement plans is that it gives the majority of the decision-making power to the employees. Hence, employees get to strategize how they can make the most of their benefits and contributions.

Taxes on 401(k) Contributions

In a nutshell, 401(k) contributions are implemented on a pre-tax basis, which means the contributions are deducted before taxes are withheld.

Let’s say an employee earns $40,000 in gross income and contributes $3,000 to their 401(k). Instead of being taxed on their $40,000 income, employees’ tax withholdings are then based on what’s left of their income after pre-tax contributions, which is $37,000.

For the 2023 tax year, individuals aged 50 and above are allowed up to $30,000 worth of contributions to their 401(k). Those aged below 50 are allowed a maximum of $22,500.

Employers will send a Form W-2 to each of their employees every January. The Form W-2 enumerates all contributions made by the employer and the employee, including the total withholding taxes paid during the previous tax year.

Taxes on 401(k) contributions also depend on whether employees are transferring their retirement savings to a new plan. This usually happens when an employee resigns and moves to a new company or employer.

Moving contributions to a new plan is otherwise called a “rollover.” Direct rollovers, which involve transferring retirement funds to a new plan, are not subject to a tax report.

However, if employees choose to have the money sent to them before the transfer, then there are specific tax implications to consider.

Is a 401(k) Tax Deductible?

401(k) contributions are tax-deferred. Income taxes are not withdrawn or paid on retirement plan contributions. Even after employees select specific investments from their retirement plan and the investments double or triple, taxes are still deferred from their contributions.

On the other hand, employees will still pay FICA taxes, and calculating their withholdings for Social Security and Medicare includes their combined gross income and 401(k) retirement contributions.

Since a 401(k) is tax-deferred, it does not qualify as a tax deduction on tax returns. Pre-tax deductions already offer employees the same advantages as a tax deduction. Hence, attempting to subtract 401(k) contributions means calculating retirement plan savings twice.

The only time taxes are paid on a 401(k) is when account holders withdraw from their retirement plan.

401(k) Withdrawal Taxes

401(k) retirement plans are established in such a way that employees or account holders can benefit from the collected funds the moment they reach the age of retirement or at least the age of 59 ½.

Once contributions are withdrawn from a traditional 401(k), the amount taken from the retirement plan becomes subject to regular income taxes. Also, withdrawn funds are referred to as “distributions.”

What about the 401(k) tax return form?

To answer the question of how to report a 401(k) withdrawal on a tax return, employees will receive Form 1099-R, and this IRS form shows the total amount withdrawn from the retirement plan. Form 1040 is where all taxable portions of the distributions are reported.

In case employees decide to withdraw funds from their 401(k) before retirement, they are subject to a 10% tax penalty. The 10% penalty is an additional tax imposed on the federal and state income taxes imposed on the withdrawn amount.

Employees are to use Form 5329 to report the 10% tax amount, including the regular income taxes applied to the distribution.

The only exception to the 10% penalty is if the withdrawal was made in response to the effect of the COVID-19 pandemic on their finances.

Roth 401(k) Withdrawals

A Roth 401(k) is a mix of both Roth IRAs and 401(k) plans. Unlike 401(k) contributions, which are deducted pre-tax, Roth 401(k) contributions are applied after-tax or net income.

All qualified Roth 401(k) withdrawals are tax-free. Similar to the 401(k), withdrawing contributions is qualified only if done once contributors reach the age of 59 ½ years old.

The contribution limit for Roth 401(k)s for 2023 was increased to $22,500 from the previously set limit of $20,500 in 2022.

If contributions are withdrawn before one reaches at least 59 ½, then these withdrawals are subject to a 10% penalty. Early Roth 401(k) withdrawals are also prorated. Part of the funds withdrawn in advance is not subject to tax consequences, while the other percentage is considered early cash out of the growth.

Alternatively, a withdrawal is still qualified if done five years after the tax year in which the first contribution was made. Workers who are transferring companies or jobs are allowed to roll over their Roth 401(k) contributions to a Roth IRA.

They can do so without incurring taxes. In case the contributor or account holder becomes disabled or departs, the contributions will go to their beneficiaries.

Final Thoughts

Investing in a 401(k) retirement plan reaps multiple benefits for employees. Some of the main 401(k) benefits include federal legal protection, high annual contribution support, and employers’ ability to match their employees’ contributions.

As such, it is important to understand the rules and conditions when it comes to withdrawing 401(k) contributions. Similarly, it is best to learn the possible penalties of early 401(k) withdrawals to avoid paying unnecessary consequences and enjoy the benefits to their full extent.