Using a 401(k) plan allows you to earmark some of your income for retirement savings, and the Internal Revenue Code rewards you with a variety of tax breaks. Because tax laws are subject to change, and the rules may vary from state to state, check with a tax professional for how the law may affect your specific situation.
Tax Impact of 401(k) Contributions
Contributing to your 401(k) plan saves you on the front end because your contributions -- and the contributions made by your employer -- aren't subject to federal income taxes. However, they aren't exempt from payroll taxes, so you'll still pay Social Security and Medicare taxes on your contributions. Though most states follow the federal tax rules for exempting contributions, a few do tax contributions. For example, in Massachusetts, contributions to 401(k) plans on behalf of partners and sole proprietors are disallowed.
Gains Within the 401(k)
Usually, you must pay taxes on money as you realize the income, whether that's interest payments each year or profits you make from selling stock. However, 401(k) plans are tax-sheltered accounts, which means that you won't pay any taxes on the gains while the money remains in the account. This helps your account balance grow faster, because you can reinvest all your profits rather than having a portion of them go to Uncle Sam.
Distributions from 401(k) Plans
Distributions from your 401(k) plan count as ordinary income in the year that you take the withdrawal, so they're taxed at your marginal tax rate rather than the lower capital gains rates. Most states follow the same rules as the IRS for taxing distributions from 401(k) plans. However, some have special exceptions that exempt 401(k) plan distributions from taxes. For example, according to the Wall Street Journal, Illinois exempts 401(k) distributions from state income taxes.
If you take money out of your 401(k) plan before you turn 59 1/2, the IRS imposes an additional 10 percent penalty on your distributions, unless you qualify under one of the exceptions. Exceptions include healthcare costs in excess of 10 percent of your adjusted gross income for the year, if you're permanently disabled or if you're taking distributions as a beneficiary from an inherited 401(k) plan.Most states don't have a similar penalty for early withdrawals, but an exception is California, which imposes an additional 2.5 percent early withdrawal penalty.