401(k) Withdrawal

Do 401k withdrawals count as income?

If you made a 401(k) withdrawal, find out if you need to report the withdrawal as an income on your tax return.

3 min read

Once you attain retirement age, you can start making withdrawals from your 401(k) retirement account. Usually, once you attain age 59 ½, you can start taking penalty-free distributions to meet your daily expenses. However, if you are not yet 59 ½, you can still make an early 401(k) withdrawal but you will be required to pay income taxes and penalties.

401(k) withdrawals are counted as income for tax purposes, and you must report the amount withdrawn to the IRS when filing annual tax returns. A 401(k) is a tax-deferred account that is funded with pretax dollars, and retirement savers do not pay taxes in the years that they contribute. Instead, the contributions are deducted from the taxpayer's taxable income, and they are only taxed when the participant takes money out of the 401(k) plan in form of distributions.

401k Withdrawals

When you contribute to a 401(k), the money is invested in different types of investments such as stocks and mutual funds. The money grows over time, and these investments earn interest and dividends. Any gains on the 401(k) money are untaxed until when you take a distribution. Unlike a traditional 401(k), a Roth 401(k) is funded with after-tax dollars, and you pay taxes when you contribute. The gains grow tax-free, and you won't owe any taxes when you withdraw money from the Roth 401(k) in retirement.

A traditional 401(K) allows retirement savers to start taking penalty-free contributions when they reach 59 ½. Since you never paid taxes on the retirement contributions, the withdrawals will be subject to the deferred income tax liability. The withdrawn amount is counted as taxable income, and you will owe income taxes at your tax bracket rate. For example, if you withdraw $5,000 and you are in the 12% tax bracket, you will pay an income tax of $600 to the IRS.

Early 401(k) Withdrawals

If you are not yet 59 ½ when you take a 401(k) withdrawal, the amount withdrawn is considered to be an early withdrawal. Withdrawing money early attracts harsh penalties, and should only be used after exhausting all other sources. The distribution is subject to income tax and an additional 10% penalty unless the distribution qualifies for a penalty exemption. If you are in the 20% tax bracket, you could owe up to 30% in taxes on your withdrawal.

Before taking an early 401(k) withdrawal, you should check with your plan to see if you can take a 401(k) loan against your retirement savings. A 401(k) loan is a better option since it allows you to eventually replace the money, and you won’t pay any taxes or penalties on the loan amount. You can borrow up to 50% of your vested balance, or a maximum of $50,000, whichever is lower. The loan payment is made using automatic deductions from your paycheck. However, if you are unable to pay the 401(k) loan, the outstanding 401(k) loan will be considered as a withdrawal for tax purposes.

Hardship Withdrawal

If you have an immediate financial need, you can take an early withdrawal without paying a penalty. You can use the hardship withdrawal to pay for college, prevent eviction or foreclosure, meet funeral expenses, and purchase a principal residence. The hardship withdrawal is considered an income for tax purposes, and you must pay income taxes on the amount when filing annual tax returns.

A hardship withdrawal allows retirement savers to withdraw money from their retirement savings account without paying the 10% penalty imposed to individuals below 59 ½. However, not all employers approve a hardship withdrawal; you should first check with your 401(k) plan to see if it allows hardship withdrawals and the specific guidelines that participants must meet.

Does Rolling Over 401(k) Count as Income?

When you rollover your 401(k) to another 401(k) or IRA, the money is transferred directly to the new retirement account. When you opt for a direct rollover, it means that you do not receive the money, hence the rollover is not considered an income.

However, if you opt for an indirect rollover, the 401(k) plan sponsor sends you a check with your balance that you must deposit to another retirement account within 60 days. If you complete the rollover in 60 days, the rolled over money is not considered an income, and you won't owe any taxes on the money. However, if you are unable to deposit the full amount to the retirement account, the transaction will be considered a withdrawal, and you will pay income taxes, and a potential penalty if you are below 59 ½.

401(k) Withdrawals Tax Form

When you make a withdrawal from your 401(k) account, the 401(k) plan will send you Form 1099-R to report the transaction. This tax form is sent to 401(k) participants who took a distribution of at least $10 from their retirement savings account. Use this tax form to disclose the amount withdrawn from the 401(k) account and the 20% withholding tax deducted by the employer.

If you made an early withdrawal before you are 59 ½, you will receive IRS Form 5329 to report the transaction. Use this form to disclose the amount withdrawn from the 401(k) account and the 10% penalty tax you owe for early distribution. You can also use this tax form to claim a 10% penalty exemption if you made a qualified hardship withdrawal.