Whoopee, you have $500,000 in your 401k plan … but do you really? Uncle Sam giveth and Uncle Sam taketh away.
Let’s say that of that $500,000, $125,000 is your contributions and $125,000 is your employer match. The balance is earnings on those investments, mostly capital gains. Remember, you have paid no taxes on any of that money.
Given the $250,000 in contributions is income to you that has been deferred, it’s fair that money should be subject to income tax. But what about the remaining $250,000 in earnings; capital gains and dividends? Most people pay no income tax on capital gains. But they do when they come from your 401k plan.
You would think that a government concerned with retirement savings could do better for retiring Americans by taking less tax from retirement savings or at least treating the gains the same as they do non-retirement investments.
But it gets worse for some. If you took a loan from your 401k plan, the interest you paid on that loan is considered earnings to the trust even when it’s credited to your account. So you end up paying ordinary income tax on the interest you paid in the first place.
Taxpayers whose taxable income falls in the top 39.6% ordinary tax bracket ($415,050 for single filers; $466,950 for married couples filing jointly or qualifying widow[er]s in 2016) are taxed at the top capital gains tax rate of 20%.
Taxpayers with income below the 25% marginal bracket pay no federal tax on long-term capital gains.
In simple terms, dividends are your share of the profits made by a company in which you own stock. The board of directors of a company can choose to distribute a portion of the company’s earnings to a class of its shareholders. Dividends can be issued as cash payments, shares of stock, or other property.
When dividends are issued to you, they’re typically considered taxable income.
Ordinary (taxable) dividends are the most common type of distribution from a corporation or a mutual fund. They are paid out of earnings and profits and are treated as ordinary income. This means they are not capital gains. You can assume that any dividend you receive on common or preferred stock is an ordinary dividend unless the paying corporation or mutual fund tells you otherwise.
Qualified dividends are ordinary dividends paid during the tax year by domestic corporations and qualified foreign corporations. which you held for at least a specified period of time. These dividends are subject to the same 0%, 15%, or 20% maximum tax rate that applies to long-term capital gains. They will be shown in box 1b of the Form 1099-DIV you receive.
And finally, what happens when your 401k account passes to beneficiaries? Well, it’s complicated, but the below link will help. That money is part of your estate and if it is taken in a lump sum, there will be a heavy income tax, but there are options. One thing to do now is check the provisions in your employer plan.