401(k) Summer School: You Won’t Owe Taxes If You Swap Investments Inside Your 401k
Hi Friendos,
401k summer school continues and here on Flag Day we have a short lesson that brings positive news.
Lesson 5: You will not owe any taxes if you swap investments inside your 401k.
Let’s say you own Fund A inside your 401k account but you’ve decided you’d rather own Fund B. Maybe Fund B is lower cost, maybe you want to rebalance your portfolio…you have a good reason. Ok, but what if you owned Fund A for several years and it went up a lot in value during that time? If this were a regular brokerage account, you’d have to pay capital gains tax on the amount of the increase.
I wrote about taxation of capital gains in this prior newsletter, and a cool technique for lower income people to avoid capital gains tax in this one and this one. But that is all about how capital gains are taxed in regular brokerage accounts, not in a tax-advantaged account like a 401k or an IRA.
In a 401k, the only potential impact on your income tax return would be when you have transactions to put money into the account or take money out of the account. With a traditional 401k, putting money into the account lowers your taxable income (in that year), and taking money out increases your taxable income (in that year). With a Roth 401k, any money you put into the account is treated as taxable income (in that year), and then there are no income tax impacts after that.
A 401k transaction that does not involve money going into or out of the account, and simply changes up the holdings inside the account, is a tax-free transaction. I favor a very simple buy-and-hold strategy of low cost index funds, so I’m not saying you should start trading with abandon, but if you conclude that some changes are in order for your 401k investments, don’t worry about a tax bill that year because there won’t be one.
-Stephanie
Frequently Taxed Questions 