In general, 401(k) contributions are not considered taxable income. This means you don’t need to report 401(k) on your tax return. However, there are exceptions to this rule. If you take any distributions from your 401(k), you are legally required to report that on your tax return. Why? This is technically considered ordinary income. Thus, you must include these earnings to ensure that your total earnings for the year are tallied up correctly since this affects what tax bracket you fall into and how much you pay in taxes.
This guide explains how a 401(k) works and defines when you do and don’t need to report your 401(k) on your tax return.
A 401(k) is a type of retirement savings plan. It was first introduced in the United States in 1978 as part of the Revenue Act. This gave taxpayers tax-free means of deferring compensation from stock options or bonuses. In 1981, Uncle Sam modified the rules surrounding 401(k) plans, allowing employees to contribute directly to their 401(k) via salary deductions.
Today, any contributions made to your 401(k) are immediately deducted from your pre-tax paycheck and directly deposited into your retirement account. These contributions are not taxable and reduce your taxable income for the year, lowering the amount of your final tax bill for the end of the year. Note that 401(k) deductions are distinct from Medicare and Social Security deductions, which also come from your paycheck.
But what happens to that 401(k) money after it disappears from your paycheck? Here’s how the process usually works:
- When you start working at a company, you are told that you are eligible for a 401(k) as part of your benefits package.
- You decide how much you want to contribute to your 401(k) plan via your employer. Usually, this is calculated as a percentage of what you earn.
- Many employers will match your employee contribution to your 401(k) plan up to a predefined amount. Not all companies provide 401(k) matching, however.
- Every pay period, the deduction you’ve specified is made, with the money taken from your gross pay.
- Your employer manages the 401(k) plan for the duration of your time with the company.
- When you leave the company, the contributions stop.
- You can then decide whether you want to leave the 401(k) plan with the same investment company used by the employer or transfer it to a new one. Another option is to transfer it to an individual retirement account (IRA).
If you consider transitioning from a formal 401(k), it’s important to understand your other options. You can choose from a Roth 401(k) or a Roth IRA. A Roth 401(k) is generally considered more suitable for high-income earners because it has higher contribution limits. Roth IRA contributions are preferable if you want to allow your investments to grow longer. Roth IRAs also provide more diverse investment options and make it easier to make withdrawals.
Times When You Don’t Report Your 401(k) on a Tax Return
So, do you have to report your 401(k) on a tax return? You don’t have to report your 401(k) if you are simply making contributions to the plan or rolling the plan over. Here’s what that means.
Contributions to the Plan
As described, your 401(k) contributions are determined by you in accordance with your employer. When you first start working for a company, they may offer you a 401(k) option and ask what percentage of your earnings you want to contribute. The contributions to your plan are then deducted pre-tax every pay period.
Your employer will not include these contributions as part of your income for that tax year. When you get your W-2 form to file for the tax year, you will see that the amount of earnings subject to federal income taxes is lower. This is because of the contributions made to your 401(k) plan. You end up with a lower taxable income, reducing the amount of federal taxes taken from your paycheck.
However, beware that you are technically only deferring the taxes on this income (the income you’ve diverted to your 401(k)). Eventually, you will receive distributions from your 401(k), at which point they will be considered taxable income. Check out the point on distributions below to learn how that works.
Rolling Over a 401(k)
As mentioned, your employer will manage your 401(k) plan as long as you work for them. When you leave that employer, you have a couple of options regarding what to do with your 401(k) plan. You can leave it with the same investment firm, or you can roll it over. What is rolling over? This is the term for when you transfer your company 401(k) plan to another 401(k) account or a traditional IRA account.
You might choose to do this for a few reasons. You might prefer to move your retirement savings to a plan administrator or brokerage you have other accounts with, thus consolidating your finances. Alternatively, you might prefer rolling over to an IRA to expand your investment options, which will likely be limited under an employer plan. In some cases, you may also find that rolling over is beneficial because it results in lower fees and expenses.
Regardless of your motivation, when you roll over your 401(k) to another account, this does not count as taxable income. The money is just transferred to a different account, and you aren’t actually getting your hands on it. There is, thus, no need to declare this as taxable income.
Times When You Must Report Your 401(k) on an Income Tax Return
You do have to report your 401(k) if you are receiving distributions from it. Here’s what that means.
Distributions From a 401(k)
When you withdraw money from your 401(k), this is known as taking a "distribution." Your 401(k) plan will specify a date by which you are required to start receiving minimum distributions. According to the IRS guidelines, you must start taking distributions after reaching age 72 or after you retire (whichever one happens later). Some 401(k) plans make distributions mandatory at age 72, even if you are still working and haven’t retired.
Distributions are taxed. At this point, you are getting your money back, so this is considered taxable income. For this reason, some people choose to roll over distributions into another qualified retirement plan (if they don’t need the money). If distributions from your 401(k) are, in fact, eligible for rollover (this isn’t always the case), you must transfer the distribution to another qualified retirement plan within 60 days of getting it. The money you roll over into another plan will not be taxable; however, you must report this activity using Form 1099-R.
If you don’t roll over distributions that you receive, they will be taxed as regular income in the calendar year that you get them.
When You Can Withdraw From a 401(k)
You might wonder if it’s possible to simply cash out your 401(k) and get your money immediately, even if you haven’t reached the minimum age of 72 or retired (which allows you to receive distributions). While it’s technically possible to withdraw money from a 401(k), it’s rarely advisable. You can only withdraw under certain conditions, and you will be subject to certain penalties if you do withdraw. Find out more below.
You’re allowed to withdraw early distribution retirement income from your 401(k) in a few instances:
- You are at least 55 years old and have been fired, quit your job, or are retired.
- You are at least 59.5 years old.
- You have an immediate financial need due to hardships (as defined by the IRS), such as medical expenses, a down payment on a house, or education costs.
- You have experienced a lifetime disability.
In general, you may not withdraw funds from your 401(k) before age 59 ½. If you are under age 59 ½ and make a withdrawal, a 10% penalty is normally applied. You also have to pay the requisite income taxes on the withdrawn funds. However, a COVID-19 stimulus measure may allow you to withdraw up to $100,000 from your 401(k) without the 10% penalty (you still have to pay the required income taxes). Additionally, you would have to replace the money taken out and pay the taxes within three years.
Borrowing is one alternative. In some cases, you may be able to borrow money from your 401(k) and pay it back via a predefined repayment schedule. While you won’t be taxed on this withdrawal, not all 401(k) plans allow for this option, and those that do will have strict accessibility criteria.
Talk to a Professional About Retirement Savings
A 401(k) is only one of your options when it comes to saving for retirement. Consult a financial services professional to get tax advice suited to your unique needs. As a small business owner or self-employed freelancer, this is especially critical since you can’t rely on employer pension funds. Don’t just rely on software like TurboTax. Talk to a tax professional who can also advise on ways to maximize tax savings and tax benefits.
When meeting with an expert, ask what financial documentation they need from you. Documents like invoices, tax returns, and bank statements can help them accurately assess your situation. You can use Skynova’s software products and business templates to help keep your financial paperwork organized.