401(k) Investment Plan Tax Consequences

Beginning in the tax year of 2006, employees may opt to use the Roth 401(k) or Roth 403(b) to have the same tax effects of a Roth IRA. In order to do this, however, the plan sponsor must amend the plan to make those options available to the employee. As a result, the following discussion does not involves Roth 401(k) accounts unless otherwise specified.

Within a 401(k) investment account, the employee does not pay federal income tax on the amount of current income that they defer to a 401(k) account. A worker who earns $50,000 in a particular year and defers $3,000 into a 401(k) account that year only recognizes $47,000 in income on that year’s tax return. This would represent a short-term $750 savings in taxes for a single employee, assuming the employee remained in the 25% marginal tax bracket and there were also no other adjustments or deductions.

Furthermore, earnings from investments in a 401(k) account (in the form of interest, dividends, or capital gains) are not taxable events. The resulting compound interest without taxation can be a major benefit of the 401(k) plan over long periods of time.

The employee ultimately pays taxes on the money as he or she withdraws the funds, generally during retirement. The character of any gains (including tax favored capital gains) are transformed into "ordinary income" at the time the money is withdrawn. Many people assume that a 401(k)'s main advantage is due to the employee being in a lower tax bracket in retirement than during working years, but this assumption is not always realistic or guaranteed to be correct, because the current capital gain rate is 15% while the marginal income tax rate on ordinary income may be as high as 35%. Given the long-term budget outlook and its inherent uncertainty, the ordinary income tax rate could once again rise to 35% or higher.

Almost all employers impose very severe restrictions on any withdrawals while the employee remains in service with the company and is under the age of 59½. Any withdrawal that is permitted before age 59½ is subject to an excise tax equal to ten percent of the amount distributed, including withdrawals to pay expenses due to a hardship, except to the extent the distribution does not exceed the amount allowable as a deduction under Internal Revenue Code section 213 to the employee for amounts paid during the taxable year for medical care (determined without regard to whether the employee itemizes deductions for such taxable year). Hardship is legally defined within the tax code as:
1. Purchase of a primary residence (specifically excludes mortgage payments)
2. To avoid foreclosure of, or eviction from, primary residence
3. Payment of secondary education expenses incurred in the last 12 months for the employee, his/her spouse, or dependent(s)
4. Medical expenses not covered by insurance for employee, their spouse, or dependent(s) which would be deductible on a federal tax return (i.e. non-essential cosmetic surgery would not be acceptable)
5. Funeral expenses for the employee's deceased parent(s), spouse, child(ren), or dependent(s) (as of December 31, 2005)
6. Home repairs due to a deductible casualty loss (as of December 31, 2005)
In any event any amounts are subject to normal taxation as ordinary income.
Some employers may disallow one, several, or all of the previous hardship causes. Someone wishing to withdraw from such a 401(k) plan would have to resign from their employer.

Many plans also allow employees to take loans from their 401(k) to be repaid with after-tax funds at pre-defined interest rates. The interest proceeds then become part of the 401(k) balance. The loan itself is not taxable income nor subject to the 10% penalty as long as it is paid back in accordance with section 72(p) of the Internal Revenue Code. This section requires, among other things, that the loan be for a term no longer than 5 years (except for the purchase of a primary residence), that a "reasonable" rate of interest be charged, and that substantially equal payments (with payments made at least every calendar quarter) be made over the life of the loan. Employers, of course, have the option to make their plan's loan provisions more restrictive. When an employee does not make payments in accordance with the plan or IRS regulations, the outstanding loan balance will be declared in "default". A defaulted loan, and possibly accrued interest on the loan balance, becomes a taxable distribution to the employee in the year of default with all the same tax penalties and implications of a withdrawal.

To maintain the tax advantage for income deferred into a 401(k), the law stipulates the restriction that unless an exception applies, money must be kept in the plan or an equivalent tax deferred plan until the employee reaches 59 ½ years of age. Money that is withdrawn prior to 59 ½ typically incurs a 10% penalty tax unless a further exception applies. This penalty is of course on top of the "ordinary income" tax that has to be paid on such a withdrawal. The exceptions to the 10% penalty include: the employee's death, the employee's total and permanent disability, separation from service in or after the year the employee reached age 55, substantially equal periodic payments under section 72(t), a qualified domestic relations order, and for deductible medical expenses (exceeding the 7.5% floor). This, however, does not apply to the similar 457 plan.