How are 401(k) withdrawals taxed?

One of the hallmark features of 401(k)s is the tax-deferred contributions and earnings. Savings money for retirement without paying taxes allows participants to contribute more money per paycheck than if they were required to pay taxes first. However, many people entering retirement don’t understand how their 401(k) withdrawals will be taxed.

401(k) withdrawals are taxed as ordinary income. When you withdraw funds from a 401(k), the plan’s administrator will send a 1099-R. The 1099-R will identify how much money is withdrawn from your 401(k). Then, depending on how much you made during that year, the IRS will tax the withdrawal amount according to your tax bracket.

Overlooking the tax obligation that comes with 401(k)s during retirement can cause some to overestimate precisely how much they have for retirement. Now it’s impossible to predict how long we’ll live. If so, it’d be a lot easier to plan out how much money we’ll need for retirement. But knowing how 401(k) withdrawals are taxed can help ensure your 401(k) lasts throughout retirement.

401(k) Withdrawal Tax Basics

401(k)s are a tax-advantaged or tax-deferred retirement savings account. Meaning, when you contribute money towards a 401(k), you won’t pay taxes on the money you put in. Additionally, the amount the 401(k) increases due to interest and market performance are not taxed until retirement.

Unlike taxable investment accounts like brokerage accounts, 401(k)s don’t pay taxes annual on capital gains.

Instead, taxes are due when the money—both contributions and growth—is taken out. Whether you are younger than 59½ or required to take mandatory distributions after 72, taxes are required for almost all 401(k) accounts. It’s important to keep in mind this tax is different from the 10% tax penalty the IRS imposes on all non-qualifying withdrawals from retirement accounts.

401(k) Withdrawal Tax Rates

There is no set tax applied to 401(k) withdrawals. 401(k) withdrawals are taxed the same way the income from your job is taxed.

Single filers who earn at least $37,650 per year are in the 25% tax bracket. If you earn at least $190,150, The 33% tax bracket starts at an annual income of $190.150. And higher net-worth individuals making more than $415,050 are taxed at 39.6%.

The tax rate that is applied to 401(k) withdrawals includes all income throughout the year. If the person tax 401(k) withdrawals and still works a job, both income sources will be used to calculate the appropriate tax rate.

An essential thing to remember is that 401(k) withdrawals can send a person into a higher tax bracket, thus increasing their tax obligation. Talk with a tax professional or a financial advisor prior to taking withdrawals as not to create more burden come tax time.

Taxes on 401(k) Contributions

Because 401(k)s are tax-deferred retirement accounts, contributions are made prior to any taxes being taken out of your paychecks. A bonus of this feature is it reduces the tax burden during your working years. This could have a positive effect if the decrease income drops you into a lower tax bracket.

Another upside to not paying taxes before putting money into your 401(k) is that you can contribute more money.

For example, if you make $90,000 per year and have a goal to save 10% of your income for retirement, you’d be saving $9,000 per year in your 401(k). However, if taxes were taken out first at a 25% tax rate, that $9,000 would shrink to $6,750.

The compounding interest gained on the difference over the course of a career can add up to hundreds of thousands of dollars.

Taxes on 401(k) Withdrawals

Though taxes aren’t required upfront for 401(k) contributions, it doesn’t mean there aren’t any tax obligations for 401(k)s. The IRS collects their taxes when funds are withdrawn from 401(k)s.

Tax is due on withdrawals from 401(k)s whether they done before 59½ or after.

The tax rate that is applicable during the year the withdraw was done will be used to determine how much taxes will be. Again, if you’re still working when you withdraw from your 401(k), that amount will be added to the money you make from your job.

Once funds are withdrawn from a 401(k) account, the plan’s administrator is triggered to file a 1099-R. This must be filed come tax time.

How to Minimize Taxes on 401(k) Withdrawals

Although there’s no way to dodge the tax responsibility altogether, there are ways to minimize the tax burden of your 401(k) withdrawals.

If you own any company stock as a portion of your 401(k), you could treat the growth of that stock as capital gains. Capital gains tax is notably lower than the income tax rate. The long-term capital gains tax rate is either 0%, 15%, or 20%, depending on your tax bracket. In order to benefit from this, you’ll need to roll over the stock into a taxable brokerage account. To prevent any mistakes that could lead to even bigger tax mess, consult an expert prior to doing so.

Another way to minimize the tax responsibility of your 401(k)s withdrawals is to look at where you fall on the various tax brackets. If taking 401(k) withdrawals sends you into the bottom of a higher tax bracket, consider taking 401(k) withdrawals earlier. This will spread out your withdrawal amounts, thus reducing your annual income amount than taking higher distributions. Doing this after 59½ will reduce your tax bill.

Are Rollovers of 401(k)s taxed?

No, so long as they are done correctly.

There are many benefits to rolling over a 401(k) to another account. Rolling over an old 401(k) to a current 401(k) helps manage all of your retirement accounts in one convenient place. Rolling over 401(k)s to an IRA provides more options to invest your retirement into.

The process of rolling over 401(k)s is simple. Contact your 401(k) plan’s administrator and give them the information of the account you want your funds rolled into. They can facilitate an ACH transfer of the funds for you.

If they insist on sending you a physical check, you’ll need to mail it yourself. The funds must reach the destination institution within 60 days to avoid the withdraw from being labeled as an early retirement distribution. This would result in income tax and possibly a 10% penalty tax.

So long as the funds reach the institution within 60 days and are rolled over to an eligible retirement, these can be done tax-free.

What About Roth 401(k)s?

Roth 401(k)s work slightly differently than traditional 401(k)s, mainly the taxes. While 401(k) contributions are made with pre-tax dollars, Roth 401(k)s are done with after-tax dollars.

In turn, when withdrawals are taken from a Roth 401(k) during retirement, there is no tax obligation. The IRS considers the taxes taken out of the paycheck prior to contributing good enough.

However, the matching contributions your employer made will be subject to taxes. While your contributions went into your Roth 401(k), your employer’s contributions went into a separate 401(k). They didn’t pay taxes on their contributions, so you’ll need to.

Final Thoughts

Knowing how 401(k) withdrawals are taxed is essential to managing your retirement accounts. By understanding what taxes you’ll be required to pay, you can better decide when to begin taking 401(k) withdrawals.

Additionally, by fully understanding how 401(k) withdrawals are taxed, you can better choose what accounts to contribute to. Perhaps the taxes during retirement through a traditional 401(k) are too big of a burden, and you’re better off contributing to a Roth 401(k). Or, if the deferred tax obligation is better for you, you’ll know what to expect down the line.