Do You Have to Report 401k on Tax Return? It Depends
401k contributions are made pre-tax. As such, they are not included in your taxable income. However, if a person takes distributions from their 401k, then by law that income has to be reported on their tax return in order to ensure that the correct amount of taxes will be paid.
Here’s What We’ll Cover:
NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need income tax advice please contact an accountant in your area.
What Is a 401k Plan and How Does It Work?
401k plans were introduced in 1978 in the United States as a way for American workers to save money by deferring tax payments on a portion of their income, until retirement.
Contributions are deducted, pre-tax, from a worker’s paycheck and deposited into an investment on the individual’s behalf.
Typically, a 401k plan works this way:
- Employee starts at a company. As part of his benefits package, he learns the company will provide him with a 401k. The employee may have to pass a certain period of time at the company before he can sign up for the plan.
- Employee is provided a range of investments to choose from.
- Employee determines how much he wants to contribute, which is typically a percentage of his earnings.
- The company matches the employee’s contribution up to a certain amount (Please note: not all employers do this, some provide the 401k without matching).
- Deductions are made every pay period:
- This money is removed from the employee’s gross pay, not the net.
- The above means the employee’s taxable income is now less than his actual salary. As a result, the taxes on each check will be lower than before the 401k contributions started.
- Company manages the 401k during the full period of time the employee is at the company.
- When the employee leaves the company, the employer contributions stop.
- Employee now has to determine what to do with the money in his 401k. He might be able to leave it with the same investment company the employer was using, or he could transfer it to a new one. He can cash it out (details on that below), or transfer it into an IRA (Individual Retirement Account)
Please note that Social Security and Medicare deduction amounts are not affected by 401k contributions.
Do You Have to Report 401k Withdrawal on Taxes?
Yes. That’s because that money is now considered taxable income.
Let’s use an example. John works at Mason Industries, a business that manufactures tools. As a foreman, he makes $90,000 annually.
John contributes to the 401k plan. Every paycheck, money is deposited by Mason Industries directly into a mutual fund that John hopes will one day fund his retirement.
John is an aggressive saver, and combined with his company’s contributions, he manages to save $8,000 a year.
After 10 years, John has 92K in his 401k (the extra 12k is the interest he’s earned). He leaves his employer and decides to “cash out” the money. The reasons why he decides to cash out are not important, what is important is this:
- John will have to pay a 10% penalty on his withdrawal because he is younger than 59½. That’s $9200. He will never get that money back.
- Income tax will be withheld at the time of withdrawal. Assuming that’s 20%, that’s $18,400 also gone.
- John’s income for the year will now be inflated. Now he has made 102k (instead of 90k) in income and will be taxed as such. The $18,400 in taxes he paid upon withdrawal will be factored in too, but he may have to pay more depending on how his income taxes work out.
- John will have less in his retirement fund.
Does Rolling over a 401k Count as Income?
A “rollover” is a transfer to another 401k account or an IRA (“Individual Retirement Account”). Since the taxpayer does not receive any money, the money being transferred is not taxable.
For instance, let’s say John decides not to cash out his 401k upon leaving his employer. Instead he does a rollover to an IRA. This transfer of the 92k will not affect his taxable income.
When Can I Withdraw from 401k?
There are certain conditions in which you can withdrawal from a 401k free of penalty. Keep in mind the “penalty” referred to here is the 10% charge for early withdrawal. Taxes will still need to be paid in most cases.
You can withdraw from your 401k early depending upon:
You are 55 years of age and you have retired, quit or been fired from a job. Or you have reached the age of 59.5 years old.
The IRS will allow a 401k withdrawal because of an “immediate and heavy financial need”. The amount removed from the 401k cannot exceed the cost of the expense (in other words, no extra).
Immediate needs can include:
- Medical care expenses (for yourself or dependents).
- Home down payment or home repair (repair because of damage, not maintenance issues)
- Education expenses for yourself or dependents.
- Funeral expenses for dependents.
- Expenses to prevent eviction.
If you become completely disabled for life, your 401k can be withdrawn from, without penalty.
A 401K Loan
You can borrow against your 401k but that money must be paid back via a repayment schedule. You may not be taxed on this withdrawal. However, it’s important to note that not all employers (who are the “plan sponsors”) provide a loan option and those that do will have certain criteria you’ll need to meet in order to qualify.
Difference Between 401k and IRA
A 401k has to be offered by an employer. An IRA (or “Individual Retirement Account”) is opened by an individual.
There are a number of differences between the two:
- An IRA has lower contribution limits than a 401k.
- An IRA has no opportunity for an employer contribution match.
- An IRA does not allow for loans like a 401k. If you remove money from an IRA, it is considered a ‘distribution’ (or withdrawal). It cannot be paid back like a loan can, and you will need to pay the penalty and taxes.