What You Need to Know About 401(k) Taxes in 2016

By Fool.com

Image: Wikimedia Commons, courtesy MIKI Yoshihito.

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More than 50 million Americans have accumulated an estimated $4.4 trillion in retirement assets using 401(k) plans, according to figures from the Investment Company Institute. 401(k) plans have gotten so popular because they offer huge tax benefits to their participants that are hard to duplicate anywhere else. Let's take a closer look at the tax implications of 401(k) plan accounts for 2016.

Contribution limits 401(k) plans include some of the most generous retirement contribution limits you'll find, easily dwarfing what you can set aside in a conventional IRA. For both 2015 and 2016, the maximum amount employees can set aside in their 401(k) accounts is $18,000 for those under age 50. Those who are 50 or older get an additional $6,000 catch-up contribution, allowing them to save as much as $24,000 in their 401(k)s.

If you participate in a traditional 401(k), then you can exclude your contributions up to the maximum amount from your taxable income, lowering your tax bill for the year. By contrast, those who choose a Roth 401(k) option get no upfront reduction in their current-year tax bill, but they enjoy tax-free treatment both during their careers and when they take distributions in retirement.

How 401(k) plans can affect your IRA contributionThe tax laws give people who are not covered by a 401(k) or similar plan at work the unlimited right to use IRAs for retirement savings. However, those who are covered by 401(k)s typically have limitations on the rights to get the full benefits of IRAs.

For traditional IRAs, having access to a 401(k) can affect your ability to deduct contributions. As the table shows below, IRA deductions start to phase out at one level of adjusted gross income and completely disappear at a higher level of income.

Source: IRS.

Even if you're not covered by a 401(k), you can have your traditional IRA deductions limited if your spouse has a 401(k) plan. As you'll see below, the income limits are higher, and they only apply in situations involving married taxpayers.

Source: IRS.

Avoiding penalties on 401(k)s Money in a 401(k) is intended for retirement, and so those who take distributions out early are usually subject to an early withdrawal penalty. However, there are several exceptions in which money taken out of a 401(k) isn't subject to the early withdrawal penalty rule:

  • Distributions to cover medical expenses to the extent that those expenses exceed 10% of your adjusted gross income, or 7.5% for those 65 or older and their spouses.
  • Distributions due to total and permanent disability.
  • Distributions as part of a series of substantially equal periodic payments over your life expectancy after you stop working for your employer.
  • Qualified reservist distributions usually made for those called to active duty for at least 180 days.
  • Distributions made due to an IRS levy of the 401(k) plan.

Even with these exceptions, however, it's important to realize that distributions will be subject to tax to the extent that they come from traditional 401(k) money. That includes not only the money that you put into the 401(k) but also any matching contributions or profit-sharing contributions that your employer deposited in your account on your behalf.

401(k) plans are a useful vehicle for saving for retirement, but it's important to keep the rules that govern 401(k)s in mind. That way, you can take maximum advantage of the tax benefits of 401(k)s while avoiding the pitfalls that cost many taxpayers a lot of money with their retirement plan accounts.

The article What You Need to Know About 401(k) Taxes in 2016 originally appeared on Fool.com.

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