At Work

Taxing issues for your 401k

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

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.


9 replies »

    • Worker money, plus employer match go into 401k before any taxes are paid plus the earnings are not taxed until withdrawn. The exception would be a Roth 401k


  1. I am surprised at the numbers that they are throwing around here in how much money that they think they will get. Because I never dreamed how much I was going to earn and how much I would save, I put a lot of money into my 401K. By the time the Roth IRA was offer, I basically had to keep in the 401K.

    Had my crystal ball been working, I would have only put enough in my 401K for the company match and invested the rest myself because the capital gains tax at 15% is a lot less than me paying my ordinary income tax rate.

    Since most American have very little saved, I cannot see how they are going to get much money out of those people.


  2. Loan interest is no more taxable than other interest you receive – because the loan is an investment in you.

    What marginal rate applies at payout. if you are worried more about taxes at term than taxes while working, use Roth, convert to Roth.

    Worried more about the taxes your survivors will pay than taxes you would pay while working, or after retirement but before death, look at Roth conversion.

    Yes, you do need to consider taxes. But if my wife and I died tomorrow, the taxable portion would be taxes to my children, both are in lower marginal tax rates than I am. I have recommended they also consider inherited provisions in the code.



      • Failed to respond. They could, I believe, take it in the form of an inherited IRA, with distributions over a lifetime. Since 2010 employer retirement plans are required to at least permit a non-spouse designated beneficiary to complete a trustee-to-trustee transfer to an inherited IRA, preserving the ability to complete a stretch IRA distribution.


  3. Another good reason to convert to Roth IRA.

    If you are going to remain in a fairly high tax bracket after retirement why pay tax on any growth.
    I converted in 2010 and have made back a good amount more in growth since then, than I had to pay in tax at the conversion. I also don’t have required minimum distributions to worry about.
    Conversions are not for everyone but it pays to check it out to see if it fits your circumstances.

    “You would think that a government concerned with retirement savings could do better”
    I think governments only concern is to see how much retirement savings they can take back.


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