As a finance expert, I often get asked whether shifting assets within a 401(k)—such as moving from mutual funds to a money market account—triggers a taxable event. The short answer is no, but the details matter. In this article, I’ll break down the mechanics of 401(k) transactions, tax implications, and key considerations when reallocating investments.
Table of Contents
Understanding 401(k) Tax Treatment
A 401(k) is a tax-advantaged retirement account, meaning transactions inside it are generally not taxable until withdrawal. This includes:
- Buying and selling mutual funds.
- Switching from stocks to bonds.
- Moving funds into a money market account.
The IRS defers taxes on capital gains, dividends, and interest earned within the account.
How 401(k) Transactions Work
When you exchange mutual funds for a money market fund within your 401(k), you’re not withdrawing money—you’re reallocating assets. The transaction happens internally, so there’s no distribution triggering taxes.
Example:
- You have $50,000 in a stock mutual fund.
- You sell the mutual fund and buy a money market fund within the same 401(k).
- Result: No tax consequences.
Comparing Mutual Funds and Money Market Funds in a 401(k)
Before making the switch, it’s crucial to understand the differences:
| Feature | Mutual Funds | Money Market Funds |
|---|---|---|
| Risk Level | Moderate to High | Very Low |
| Return Potential | Higher (5-10% avg.) | Lower (~1-3%) |
| Liquidity | T+1 Settlement | Immediate |
| Best For | Long-term growth | Short-term stability |
When Should You Move to a Money Market Fund?
- Market Volatility: If you’re nearing retirement and want to protect capital.
- Short-Term Cash Needs: If you anticipate needing liquidity soon (though early withdrawals may incur penalties).
- Rebalancing Strategy: To temporarily park funds before reinvesting.
Tax Implications of 401(k) Withdrawals
While internal transactions aren’t taxable, withdrawals are. If you take money out of the 401(k), the IRS treats it as income.
Taxable Withdrawal Example:
- You withdraw $20,000 from your 401(k).
- If your marginal tax rate is 22%, you owe:
20,000 * 0.22 = $4,400 in taxes.
Early Withdrawal Penalties
If you’re under 59½, the IRS imposes a 10% penalty on top of income taxes.
\text{Total Tax} = (\text{Withdrawal Amount} \times \text{Income Tax Rate}) + (\text{Withdrawal Amount} \times 0.10)Example:
- $10,000 early withdrawal at 24% tax rate:
(10,000 * 0.24) + (10,000 * 0.10) = $3,400 total cost.
Rollovers and Indirect Tax Risks
If you move funds out of the 401(k) (e.g., into an IRA or another account), tax rules change:
- Direct Rollover (Trustee-to-Trustee): No tax withholding.
- Indirect Rollover (60-Day Rule): The IRS withholds 20%, and you must deposit the full amount within 60 days to avoid taxes.
Mistake to Avoid:
- Taking a check from your 401(k) and depositing it yourself (indirect rollover). If you fail to complete the transfer in time, it counts as a taxable distribution.
Practical Example: Reallocating Without Tax Consequences
Let’s say Jane, 45, has:
- $100,000 in a 401(k) stock fund.
- She moves $30,000 into a money market fund within the same plan.
Tax Impact:
- No tax because it’s an internal transfer.
- She retains the full $30,000 without IRS penalties.
Conclusion
Moving from mutual funds to a money market fund inside a 401(k) is not taxable. However, withdrawals or rollovers can trigger taxes and penalties. If you’re reallocating for stability or liquidity, the transaction itself won’t cost you—but always confirm with your plan administrator.
