Since the money in your 401(k) account is qualified retirement money under the tax rules, you will never pay capital gains taxes, no matter how large your 401(k) grows. However, this does not mean you get out of paying taxes. It means you pay taxes under the retirement plan rules and not the capital gains rules.
Capital Gains Taxes
In general, capital gains taxes are paid on the profit you make when an investment is sold for more than you paid. Your investment gains are taxable only if you buy and sell the investments in a regular, taxable account. Investments owned in a regular brokerage or mutual fund account can produce taxable gains that you must include on your tax return. One indication that taxes need to be paid will be the Form 1099 you receive showing investments sold and capital gains distributions.
401(k) Tax Deferral
The money in your 401(k) account has never been taxed. Contributions go in before tax, reducing your taxable income by the amount you contribute each year. The same applies to matching contributions paid by your employer. Gains on your 401(k) account value also grow tax-deferred, including mutual fund capital gains distributions paid on funds you hold in your retirement plan account. You can view your entire 401(k) account balance as a sum of money that has never been taxed.
401(k) Withdrawals Are Income
When you take withdrawals from your 401(k) account, that money becomes regular taxable income to you. You report retirement plan payments on your taxes as income and not as investment gains or investment income. Withdrawing from your 401(k) in retirement produces the same type of taxable income as earning a salary or wages when you were working. Any and all money you take from your 401(k) account must be reported as income for the year of withdrawal. If you take money from your 401(k) before age 59 1/2, an extra 10 percent tax penalty will apply.
Under the tax rules, your 401(k) savings are deferred earned income, not investment income. When you take 401(k) withdrawal the full amount is taxable income and the tax rate will be your regular income tax rate. Capital gains taxes apply to gains you generate on investments not in a retirement plan. Gains on investments owned for longer than one year are taxed at a lower rate than your regular income. The earnings you make in your 401(k) account are a different type of income from capital gains from regular investments and each is treated differently by the tax rules.