The way you pay taxes on your 401(k) contributions depends in large part on the type of account you have; if you have a traditional 401(k), you do not pay income tax on your contributions until you withdraw them. If you have a Roth account, however, you pay income tax on all your income, including contributions, in the year you earn it. Income from traditional 401(k) distributions taken after age 59.5 is taxed at your current income tax rate. Qualified distributions from a Roth account are completely tax-free as long as you have owned the account for at least five years and have reached age 59.5
The only difference between traditional and Roth 401(k) accounts is the source of the funds you contribute. Traditional 401(k) contributions are made with pretax dollars, meaning an amount of your choosing is allocated to your plan before income taxes are assessed.
Assume you earn $2,000 each pay period and pay 20% in income tax. Say, for the sake of simplicity, no other taxes are withheld, though deferrals to traditional 401(k) accounts are still subject to FICA taxes. The amount of $400 is withheld from each paycheck to pay income taxes. If you defer $500 from every paycheck to a traditional 401(k), your income is reduced by that amount before income tax is assessed. Your 401(k) deferral reduces your taxable income to $1,500 each pay period, which reduces your tax withholding to $300. Your take-home pay is $2,000 - $500 - $300, or $1,200.
When you withdraw funds from a traditional 401(k) after retirement, the IRS requires you pay income taxes according to your new tax bracket. This is why people who believe they will be in a lower bracket after retirement prefer traditional accounts.
Conversely, contributions to Roth accounts are made with after-tax dollars. You pay income tax on the full amount of your earnings, and your 401(k) contribution is deducted after taxes are calculated. In the above example, a $500 contribution to a Roth 401(k) does not reduce your income tax withholding at all. You still pay $400 in income taxes before the $500 contribution is taken. Your take-home pay each period is $2,000 - $400 - $500, or $1,100.
Contributing to a Roth account may seem like a raw deal since you do not enjoy any tax benefits during your working years. However, withdrawals made after retirement are completely tax-free. You have already paid income taxes on your contributions, and the terms of Roth accounts stipulate that earnings are also tax-free if withdrawn after age 59.5.
The above taxation rules apply to contributions and qualified withdrawals of 401(k) funds. However, if you want to withdraw 401(k) funds before you reach 59.5, you are subject to additional taxation. If you have a traditional 401(k), early withdrawals of retirement funds are taxed at your ordinary income tax rate. In addition, the IRS imposes a 10% penalty tax on the amount of your withdrawal.
If you have a Roth account, the rules are slightly more lenient. Because income tax has already been paid on Roth contributions, any withdrawals composed of contributions alone are tax-free at any time. However, most 401(k) accounts make distributions composed of contributions and earnings. Any portion of a premature withdrawal attributable to earnings is taxed at your ordinary income tax rate and is subject to the same 10% penalty tax outlined above.
There are a few exceptions to this rule, such as for withdrawals made after the account owner dies or becomes permanently disabled, or to pay for unreimbursed medical expenses that exceed a certain amount. In addition, you may be able to qualify for a hardship distribution if you can prove you have an immediate and heavy need of funds that cannot otherwise be met. In general, however, most withdrawals made before you reach 59.5 will incur this additional tax penalty.