Nearing Retirement, Retirement Planning

Tax Free 401(k) Withdrawals? Maybe…

No, this isn’t a political prediction on who’s going to win the White House and what they might say about your taxes. And no, I’m not claiming that there will be massive tax law changes that will drastically change the way you pay taxes on your savings. I am concerned you may not fully understand your savings options.

I came across a situation recently that might be more common than I wish it were.

  • Saving into your employer sponsored retirement plan? A good thing.
  • Not knowing how that savings will be taxed when you retire? A bad thing.

While employer sponsored plans are governed by their own plan documents, generally speaking, there are three ways to save into your employer plan and each drastically affects the end result.

  1. First and most common is to save pre-tax, meaning you get a tax deduction for saving in this manner. The money compounds on a tax-deferred basis but then the whole kit and caboodle (contributions AND investment earnings) is taxed as ordinary income when you take withdrawals.
  2. In addition, some plans allow for “Roth contributions”, meaning the investor contributes money that has already been taxed (no deduction now) but enjoys tax-free compounding; withdrawals of contributions AND investment earnings are tax-free when you take withdrawals.

Now this is where it can get confusing…

  1. Finally, there may be an option to save “after-tax.” Much like a “Roth contribution,” after-tax contributions are made with money that has already been taxed. However, the investment earnings ARE taxable, making only the contributions tax-free upon withdrawal. So unlike the Roth contributions, the earnings of after-tax contributions compound on a tax-deferred—not tax-free—basis. That’s often the misleading part…Even though the earnings are taxable, when given the ability to rollover 401(k) assets, the after-tax portion IS eligible to move to a Roth IRA, where future investment earnings ARE tax-free.

If given the option, Roth 401(k) contributions are typically better than after-tax contributions, if tax-free investment earnings are the goal. But, after-tax savings that can become a Roth IRA in the future may be better than no Roth at all!

Now, if you want to save into all three – go for it! The savings limits for after-tax contributions can exceed the traditional $18,000 allowed in a 401(k) in a year (plus $6,000 catch-up for those over the age of 50). Yup, after-tax contributions can exceed $18,000 or $24,000, as long as total 401(k) contributions don’t exceed $53,000.  But that’s a story for another day…

Check your 401(k) statement. Make sure you’re saving as you intended. After-all, there would be few things more frustrating than finding out years from now the money you THOUGHT you’d never pay taxes on, is indeed taxable.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Please consult a financial professional prior to taking any action.

 

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