The 401(k) Tax Trap

Posted by Badger Coach on June 9th, 2014

If you have been or are currently employed, you probably sat in a class for new hires, where a financial representative or someone from the H.R. department told you about the benefits and importance of saving money through pre-tax deductions in an Employer Sponsored Retirement Plan (ESRP), such as a 401(k), 403(b), 457, or Thrift Savings Plan. But what they did not tell you may make you unhappy.

401(k) Sales Pitch

To really make you feel like an idiot if you do not participate in an ESRP, you are told that Uncle Sam will allow you to make contributions on a pre-tax basis, thus lowering your taxable income. And then to make it more enticing, you are told that your employer’s matching contribution is “free money” and that all contributions into the ESRP and their stock market earnings will grow tax-deferred for as long as the money remains in the ESRP or IRA Rollover Account. All of this is true. What a deal, right?

401(k) Taxes

What you are not told about ERSPs is that they are a wealth-draining tax trap. The following is a list of ways your money may be taxed once it enters your ESRP or IRA account.

Contribution Tax

Uncle Sam charges you an upfront tax on any contribution classified as “elective deferrals” that were made by you or on your behalf by your employer. For each contribution made you will pay Social Security (6.20%) and Medicare (1.45%) tax. This is what I call a 401(k) contribution tax.

To help you gain a better understanding of how your 401(k) money is taxed, the IRS states the following:

  1. Elective deferrals (other than designated Roth contributions) aren’t subject to federal income tax withholding at the time of deferral and …
  2. Although the law doesn’t treat amounts deferred as current income for federal income tax purposes, they are included as wages subject to Social Security (FICA), Medicare and federal unemployment taxes (FUTA).

What this means to you is that contributions that you and your employer make to your 401(k) account do not count as income and may be deducted for federal income tax purposes. However, employee and employer contributions are counted as income for Social Security and Medicare tax purposes. Uncle Sam wants his money first. For example, if you contribute $250 per pay period towards your 401(k) account and your employer matches your contribution for a total of $500 per pay period, depending on your federal income tax rate, you may deduct a percentage of the $500 for federal income tax purposes.  However, Uncle Sam will hit you with a 401(k) contribution tax of 15.3 percent before your money is deposited into your 401(k) account. As you can see, Social Security and Medicare tax completely destroy any benefits of an employer match. The good news is that your employer covers half of this tax.

Further, it should be noted that starting with the 2014 tax year, individuals earning more than $117,000 do not pay Social Security tax or Medicare tax, which is why ESRPs benefit higher income earners than lower income earners, as indicated in a recent Harvard study.

So, the next time you are in a retirement class at work and the sales rep tells you that you are using pre-tax dollars when you invest in your 401(k) account, you now know that this is not completely accurate.

Early Withdrawal Tax

To make it hard for you to access your money inside of an ESRP, Uncle Sam will hit you with a 10% early withdrawal tax. The money that is withdrawn will be added to your income for the tax year in which the withdrawal is made and will be taxed at income tax rates. If you have already concluded that you could wind up paying a 35% or more tax penalty on your early withdrawal, you are right. One way to get around the early withdrawal tax is to make sure your withdrawals qualify as a penalty-free “triggering event”.  However, if you are financially strapped, you may be able to declare financial hardship and get hit with a 10% early withdrawal tax. Even in that scenario, you must repay the money within five years or before you separate from service with the company, or you will incur the early withdrawal and income tax penalty. However, all is not lost. If you want to retire early and also avoid the 10% penalty, you can take advantage of a gift from Uncle Sam. A special provision in the tax code known as IRC 72(t)(2)(A)(i) allows you to withdraw funds in substantially equal and periodic payments up through age 59½ and avoid the 10% penalty. This strategy works best if you are at least 55 years of age or older.

Retirement Income Tax

If you are age 59½ or older and are ready to retire, you will have to pay taxes on all of the money inside your ESRP that you contributed, that your employer contributed, and on any gains from the stock market. The good news is that you may withdraw the money from your ESRP and not be required to pay the 10% early withdrawal tax. However, you will be required to pay income tax on the money that you do withdraw. So, basically, your money is being tax twice (contribution tax and ordinary income tax) before you receive it.

Required Minimum Distribution Tax

If you decide to delay withdrawing the money inside your ERSP at age 59½ until age 70, you are permitted to do so. However, once you turn 70½ years old, you must take withdrawals from your ESRP or IRA account, or Uncle Sam will hit you with—what I call a—50% delay-of-game tax. This tax is technically known as the Required Minimum Distribution (RMD) tax. The RMD rules require you to take a certain amount of money out of your ESRP or IRA account each year or else you will have to pay a 50% tax on the dollar amount that you are required to withdraw that year. The good news is that you do not have to figure out how much to withdraw because Uncle Sam will let you know ahead of time.

Inheritance Tax

For estate tax purposes, Uncle Sam allows spouses to transfer assets, including ESRPs or IRAs, tax free to each other. This transfer is called the “basic exclusion.” For the 2014 tax year, the lifetime cap on these transfers is $5.34 million per person or $10.68 million per couple. These transfers usually take place after the death of a spouse. Withdrawals for income purposes will be taxed at ordinary income tax rates.

The bad news is that these exclusions on transfers do not apply to transfers to children or non-spousal relationships. This means that if you allow anyone other than your spouse to inherit your ESRP or IRA, they will have to pay an inheritance tax on the money you gave them. And remember, inheritances are taxed at income tax rates, not capital gains rates, for non-spousal beneficiaries.


Because of all the tax traps and the uncertainty of the stock market, voices within the media are now declaring 401(k) plans a failure.  I have long held this belief and suggest you consider using an after-tax 401(k) alternative  to fund your retirement. However, your financial advisor will probably suggest otherwise and show you that pre-tax retirement accounts will have larger ending account balances than the ending account balances of an after-tax retirement plan. He is also likely to say that my strategy is not a good idea, because of the tax deductions. However, once you factor all of the taxes that you will have to pay back throughout retirement because you were in an ESRP, you may wind up netting less in income, net of taxes, if you use a 401(k) plan instead of  an after-tax retirement plan. The reason that an after-tax retirement plan is so attractive is because any income you receive from this account, may be taxed at capital gains tax rates, tax-exempt tax rates, or tax-free rates, and can be risk-free, whereas a 401(k) is taxed at ordinary income tax rates and your investments are at risk. Contact a qualified accountant or financial consultant that specializes in tax-preferred retirement strategies to help you plan for your future.


ESRP’s should not be called tax savings plans. They should be called tax-delayed plans. If tax rates are higher when you retire, investing in a ESRP may not have been a wise thing to do. And, when you add up the overall cost (i.e., taxes, fees, personal contributions and investment risk) for you to build a retirement nest egg, an ESRP may be the most costly way for you to do it. Remember, the only thing that matters is what you net after expenses, not what you earn.




The opinions expressed are those of the author and is for educational purposes only, and not an offer to buy or sell securities.  Use this information at your own risk. Investing involves significant risk, even the loss of capital. Invest only what you can afford to lose. Past performance is not indicative of future results. Guarantees provided by an insurance company are based on its claims paying ability. Policy loans will reduce the death benefit, until repaid in full.  Upon termination (not death of policy holder) of a policy, unpaid loans and the accrued/capitalized interest will be taxed as ordinary income.   Unpaid policy loans may be  taxed at ordinary income tax rates in the year of the  lapsed, surrendered, or terminated policy. As always, please consult with a qualified legal, tax, insurance or investment professional before making any investment or insurance decision.


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