A guide to understanding 401(k) taxes

A 401(k) is a powerful tool to help you save for retirement and achieve your future dreams. But to get the most from your account, it's important to understand 401(k) taxes.

Whether you've just begun saving for retirement with a 401(k), you're changing jobs and need to decide what to do to with your 401(k) savings, or you're getting set to take withdrawals, taxes matter. Understanding 401(k) taxes and how they work will help you shape your best plan for the future. Here's what to know.

A 401(k) offers several key tax advantages that can help boost your retirement savings. The most notable is tax-deferred growth, meaning you won't pay taxes on your investment gains until you withdraw the money. This allows your savings to compound faster since more of your money is working for you instead of going to taxes.

Your employer may offer you the choice between a traditional and Roth 401(k). Since they are taxed differently, the tax advantages will vary by the type of plan you choose. We'll cover the differences below.

Get a refresher on traditional vs. Roth 401(k)s

401(k) taxes work differently at the point of contribution, investment earnings and withdrawals for traditional and Roth 401(k)s:

• Contributions: Traditional 401(k) contributions are made with pre-tax dollars, lowering your taxable income in the year you contribute. This may make it a good option if your income is currently high. Depending on how much you contribute, lowering your taxable income could lead to a significant tax savings.
  
• Earnings: Taxes are deferred on any earnings in your traditional 401(k) until you withdraw the funds. This gives them time to compound over time.
  
• Withdrawals: Traditional 401(k) withdrawals are taxed as ordinary income at your current tax rate. You'll also need to take required minimum distributions (RMDs) starting at age 73 (or 75 if you were born in 1960 or later).
  

• Contributions: Roth 401(k) contributions are made with dollars that you've already paid taxes on, so there's no immediate tax benefit.

• Earnings: A key benefit of a Roth 401(k) is that investment earnings grow tax-free. This puts the earnings from Roth accounts into the "tax-never" category.

• Withdrawals: Since taxes were already paid on Roth 401(k) contributions, no additional taxes will be due on qualified distributions when it's time to withdraw the funds. And, unlike traditional 401(k)s, no RMDs are due for Roth 401(k)s. That means you can leave the money in the account to grow and compound as long as you'd like.

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Creating a Roth IRA can make a big difference in your retirement savings. All future earnings are sheltered from taxes under current tax laws. If you meet a qualifying distribution event, a Roth IRA can provide truly tax-free growth potential.

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When you change jobs or retire, you might consider rolling your 401(k) over into an IRA. A rollover allows you to maintain the tax-advantaged status of your savings and gives you more control over your investment options. Consider these ways to move your 401(k) funds into another account:

You can complete a transfer by moving funds from one retirement account to another account of the same type without paying taxes or incurring a penalty. For example, you can transfer balances from your old employer's 401(k) plan to your new employer's 401(k) plan. Your funds continue to grow tax-deferred, and you won't owe taxes until you start making withdrawals.

This typically doesn't trigger any immediate tax consequences but follow the rules carefully to meet deadlines and avoid surprises come tax season.

There are two main ways to roll over your 401(k): through a direct or indirect rollover.

• Direct rollover. With a direct rollover, your 401(k) provider sends the funds to your IRA or your new qualified plan. This is the most straightforward and tax-efficient method.

• Indirect rollover. With an indirect rollover, you receive a check for the distribution and have 60 days to deposit funds in your IRA. Note that 20% of the distribution will be withheld for taxes. You'll need to deposit the full amount, including the withheld taxes, to avoid paying taxes and potential penalties.

Some rollovers may have tax implications due to IRS regulations and rules, so before making any changes, you may want to consider consulting a financial advisor for the best strategy.

Converting your 401(k) to a Roth IRA can be a strategic move for your retirement savings, but you'll need to understand the tax implications.

• Converting a traditional 401(k) to a Roth IRA is taxable. Because contributions to a traditional 401(k) are made with pre-tax dollars, the amount you convert will be added to your taxable income for the year. This means you'll owe taxes on the converted amount at your ordinary income tax rate.

• A rollover from a Roth 401(k) to a Roth IRA is tax-free. Contributions to Roth 401(k)s are made after you've paid taxes on the contributed amount. Your savings continue to grow tax-free, and qualified withdrawals remain tax-free.

While withdrawing your hard-earned savings may be tempting, cashing out a traditional 401(k) completely can have serious tax consequences. When you withdraw your entire balance as a lump sum, the amount is treated as ordinary income and taxed accordingly.

It can push you into a higher tax bracket for the year, resulting in a hefty tax bill. Additionally, if you're younger than 59½, you may face an early withdrawal penalty of 10% on top of the income taxes owed. You could lose a significant portion of your savings to taxes and penalties.

• Tax impact. A lump-sum withdrawal can increase your tax liability for the year.
• Early withdrawal penalties. If you're younger than 59½, you may be subject to a 10% penalty in addition to income taxes.
• Loss of retirement savings. Withdrawing your funds depletes your retirement savings, leaving you with less for your future.
• Limited options. It's possible to do an indirect 60-day rollover. However, once you've cashed out, you can't undo this decision to recoup the lost tax benefits.

It's important to consider the tax consequences and weigh the benefits against the drawbacks before you decide.

As you approach retirement, you'll want to be aware of how 401(k) withdrawals, or distributions, are taxed.

• Before age 59½. If you withdraw money from your 401(k) before reaching 59½, you may face a 10% early withdrawal penalty on top of regular income taxes. However, there are certain exceptions. See the full list of exceptions

• After age 59½. After reaching 59½, you can withdraw from your 401(k) penalty-free. However, any withdrawals are treated as ordinary income and taxed according to your current tax bracket.

• Required minimum distributions (RMDS). RMDs start once you turn 73 (or 75 if you were born in 1960 or later) and are taxed as ordinary income. The amount is based on your age and account balance at the end of the previous year. Withdrawals may increase your taxable income and push you into a higher tax bracket.
  

• Qualified distributions. Withdrawals are tax-free if you're older than 59½ and the account has been open at least five years.

• Non-qualified distributions. If you withdraw funds before age 59½ or haven't met the five-year rule, your withdrawals may be subject to taxes and penalties on the earnings.

If you leave your 401(k) as-is after retiring or leaving your employer, the money continues to grow tax-free. Roth accounts don't have RMD requirements.

Explore more tips for what to do with your 401(k) when you retire

Navigating the tax implications of your 401(k) doesn't have to be overwhelming. Here are some strategies to help you minimize your tax burden and make the most of your retirement savings:

• Make a strategic Roth conversion. If you anticipate being in a higher tax bracket in retirement, consider converting some of your 401(k) to a Roth IRA or a Roth 401(k), if your plan allows.

• Time your withdrawals. Spread withdrawals over time to avoid jumping into a higher tax bracket.

• Consider qualified charitable distributions (QCD). If you're 70½ or older, you can currently donate up to $105,000 from your IRA to a qualified charity through a QCD. You’d need to first roll the funds from a 401(k) into an IRA and then make the QCD. Then this donation can count toward satisfying your RMDs without increasing your taxable income.

• Roll over your 401(k). If you change jobs or retire, rolling over your 401(k) to an IRA can give you more control over your investments and potentially lower fees.

• Delay Social Security. By delaying Social Security benefits, you can increase your monthly payments and potentially reduce your overall tax burden in retirement.