401(k) plans are employer-sponsored retirement plans that allow you to save pre-tax dollars for use in retirement. Employers often match a certain portion of what you contribute, and the money in the account grows tax-free until you choose to withdraw it. At that point, any money you withdraw, including dividends from stocks and mutual funds, is taxed at your ordinary income rate.
Dividends are a share of the profits earned by an individual company or mutual fund. Companies often pay out dividends when they have excess profits for which they have no better purpose. Dividends are usually taxed at your ordinary income tax rate, unless they are considered qualified, in which case they are taxed the same as capital gains.
Taxes on Dividends
When you own stocks and mutual funds in a taxable account, you have to pay taxes on any dividends you receive in excess of $10 annually, even if you reinvest those dividends. The company that paid you the dividends will send you IRS form 1099-DIV, which you use to report the dividends on your income tax return. Most dividends are taxed as ordinary income. On the other hand, the taxes on dividends paid on investments held in a 401(k) account are deferred until you take the money out of the account.
The IRS allows you to start withdrawing funds from your 401(k) without penalty when you reach age 59-1/2, even if you are still working. Any money you withdraw, including your contributions and any earnings from capital gains or dividends, is taxed at your ordinary income tax rate. The advantage to deferring the taxes on these investments is that many people fall into a lower tax bracket when they retire, meaning they pay less in taxes than they would have had they paid taxes on the money up front.
Not all dividend-paying investments are appropriate for 401(k) plans. For example, there are certain municipal bonds and bond funds that are exempt from federal or state taxes, meaning you are paying more taxes than necessary by holding them in a tax-deferred account. Also, you can incur tax penalties on top of your income taxes if you withdraw your money too early or too late. If you withdraw money from your 401(k) account before age 59-1/2 without declaring a qualifying financial hardship, you will pay a 10 percent tax penalty on top of any income taxes you owe on the withdrawal. On the other hand, if you do not start withdrawing money from your 401(k) by April of the year after you turn 70-1/2, you can face a tax penalty of 50 percent of the minimum amount the government determines you should have withdrawn.