Ahhh, the 401k.  The former 201k of the year 2009.  I can’t tell you how many times in 2009 I heard the joke:

“I had a 401k, now I have a 201k”.

Funny I don’t hear those same people referring to it as a 601k after an incredible 7+ year bull market.

Pretty much every American knows what a 401k plan is.  In fact, I’ve even spoken to foreigners who know about 401k plans. Just the other day I was talking to a gentleman from South Africa who randomly knew what a 401k plan was, and he doesn’t even live in the US.  This didn’t necessarily surprise me, considering how many conversations I’ve had with foreigners who somehow know more about the US than I do.

While many people know some basics of 401k plans, they may not understand the details of a 401k plan; such as how their plan is taxed.  This article is going to tackle the important aspect of how a 401k plan works with your taxes.

A 401k is referred to as a qualified retirement plan.  The key word here is qualified.  Qualified plans allow an employer a tax break against money added to an employee’s 401k.  The employee is also allowed to take a tax deduction for the amount contributed to a plan during the tax year of the contribution up to a limit.

If I have confused you already, don’t worry.  We will explain this further as we go on.

Take the following two people who both make $60,000 per year. 

Person A contributes $0 to a 401k.                                

Person B contributes $5,000 to a 401k.

Person A:

Contributes $0 to their 401k and has annual income of $60,000

• Effective tax bracket = 15%
• Taxable Income = $60,000
• $60,000 X 15% = $9,000 tax

Person B:

Contributes $5,000 to their 401k and has annual income of $60,000

• Effective tax bracket = 15%
• Taxable Income = $60,000 – $5,000 = $55,000
• $55,000 X 15% = $8,250

If Person B contributes $5,000 to their plan, they would be allowed a tax deduction against that year’s income.  To be overly simplistic, if person B above makes $60,000 per year and contributes $5,000 to their 401k plan (and has no other tax deductions), they will be taxed as if they made $55,000.  By contributing to the 401k plan, person B is now taxed on $55,000 instad of their gross income of $60,000.

Person A’s effective tax bracket is 15%.  Person A would pay $9,000 in taxes if they earned $60,000 that year.

Person B, on the other hand, will have a tax bill of $8,250 that year.

The contribution saved Person B $750 in taxes that year.

But, hold the phone, because Uncle Sam is going to get his money.  Many do not realize that the 401k is not a tax free contribution but a tax deductible qualified contribution that is deferred until an employee takes a distribution.

Whoof, that last sentence was a little crazy.  Let’s break down that that means:

Understanding the Words of the Taxman

Tax Free Contribution – to make a tax free contribution would mean you would pay no tax when you distribute money from the plan down the road.  401k plans do not fall under this category since distributions are taxed.

Tax Deductible Contribution – this contribution allows an individual to deduct the amount contributed to the 401k plan from income.  Don’t confuse this with a tax free contribution!

Tax Deduction – a tax deduction is the amount the employee is able to deduct from their income for tax purposes.

Tax Deferred – when an account is tax deferred an employee’s tax is simply deferred to a later date.  For 401k plans, that date is whenever money is distributed from the 401k.

When person B decides in retirement to take a distribution to use the money, they have to pay taxes on that money at their income tax bracket at that time.

It will look like this if Person B distributes $55,000 in retirement:

• Effective tax bracket = 15%
• Taxable income (distribution from 401k account in retirement) = $55,000
• $55,000 x 15% = $8,250 tax paid on 55k distribution from 401k that year

If person B saves $1 million for retirement in their 401k, the entire $1 million is tax deferred.  Person B will owe taxes on the entire amount in the years they make distributions.  If person B distributed $55,000 during retirement, Person B would pay income tax on the $55,000 they distributed and owe $8,250 on the $55,000 distribution.

So, Uncle Sam, who we all thought was the fun uncle who brought us the best presents when we were younger, ends up being the uncle who stops at your house when you are all grown up, raids your fridge, wrecks your car, and refuses to leave until you buy him and his girlfriend, Jewel, a plane ticket back to their apartment in Vegas.  Basically, maybe Uncle Sam isn’t who you thought he was when you were younger.

What you thought Uncle Sam looked like when yo were younger:

What Uncle Sam really looks like:

A few more tax tidbits you may need to know about investing in a 401k plan. 

Let’s say someone distributes money from their 401k plan before age 59 ½, that person will likely be paying a 10% penalty.  A 401k plan is considered a retirement plan; Uncle Sam doesn’t want you to be able to distribute money from your 401k plan before you are near an age which is acceptable for retirement.

Unfortunately, my idea of retirement is age 45 plus or minus about 3 years.  So maybe I’m going to have a problem with my 401k plan when I decide to retire, but I digress.

The 10% penalty for withdrawing money before age 59 ½ from the plan does have a few exceptions.  For example, if someone is purchasing their first home, they may be able to distribute money up to a limit for the purchase of the home.  If an individual is disabled that person may be entitled to early withdrawals and if someone has unreimbursed medical expenses which exceed a certain ratio of adjusted gross income they may qualify as well.

There are other elusive ways to access money, but we don’t get into them in this post.

Who out there invests in 401k plans?  Any of you out there think Uncle Sam is a little weird?
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photo credit: Got Credit Income Tax via photopin (license)