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401(k) withdrawal taxes

Reaching retirement age can be exciting, but also nerve-wracking in regards to money matters. One of the first questions you may have, is what happens you start withdrawing from your 401(k)? You’ve spent years contributing to your account, and now it’s time to use your retirement savings. Or, perhaps you’re well below retirement age but are doing your research the future. Regardless of your reason why, learning about 401(k) withdrawal taxes ahead of time might save you from a nasty surprise. 

Find a financial advisor to address your retirement concerns.

Are 401(k) Distributions Taxable?

The short answer is yes, your 401(k) distributions are taxable. You might not know this because some of the confusion around how retirement accounts work. The term tax-advantaged (or tax-deferred) is often used in conjunction with retirement accounts. What this means is your investments within your 401(k) (or traditional or Roth IRA) grow tax-free. Unlike taxable investment accounts, you won’t be charged income tax or capital gains tax as your 401(k) account grows each year. However, things change once you start receiving distributions from the 401(k). As you pull money out, you’ll owe incomes taxes on the funds. Some 401(k) plans will automatically withhold 20% or so of your account to pay for taxes. You’ll want to check with your plan provider to see how your particular 401(k) works.

Wondering when you can start cashing out? Once you reach age 59 1/2 you can withdraw money from your 401(k). If you don’t need the money yet, you can wait until you reach age 70 1/2 to withdraw funds. However, once you reach 70 1/2, it’s no longer a choice to withdraw from your 401(k), it’s mandatory. The IRS has defined required minimum distributions for certain retirement accounts, including 401(k)s.

What Is the 401(k) Tax Rate?

401(k) withdrawal taxes

Your 401(k) withdrawals are taxed as income. There isn’t a separate 401(k) withdrawal tax. Simply put, any money you withdraw from your 401(k) is considered income and will be taxed as such. At the very least, you’ll pay federal income tax on the amount you withdraw each year. Retirees who live in states that have additional income taxes, such as California and Minnesota, will have to pay that as well.

You can calculate how much you’ll owe for income tax to help plan ahead. If you’re using your 401(k) to replace your previous salary, you can expect similar taxes as years prior. However, if you’re planning on living on less, and limit your withdrawals, you might find yourself in a lower tax bracket. If that’s the case, you’ll owe less in taxes because of your income drop.

What Happens if You Withdraw Your 401(k) Early?

You might find yourself in a situation where you need the money in your 401(k) before you reach 59 1/2 years of age. The account is designed to be part of your retirement plan, but circumstances come up where you can’t avoid dipping into the money for other reasons. Down payments, emergency medical bills and education costs are a few examples of expenses some people pay with 401(k) funds.

If this is the case for you, expect to pay a 10% penalty fee. This is on top of the income tax you’ll pay for withdrawing the funds. Remember, even if it’s paying for an emergency, it’s still counted for tax purposes as income. You’ll want to run the numbers, adding the tax and penalty tax, to see if it makes sense to pull money out early. It’s also important to factor in the loss of investments over time, as well.

In some cases, there is an exception to the 10% additional tax. The IRS lists the circumstances where the tax doesn’t apply. Losing your job at 55, or starting a SOSEPP (series of equal periodic payments) plan are two examples.

The Takeaway

401(k) withdrawal taxes

Retirement may mean an escape from work, but unfortunately, it’s not an escape from taxes. Stay ahead of the game by budgeting what you’ll owe the government each year. That way, you can enjoy your retirement knowing that you won’t be surprised by the tax bill. It’s always better to be proactive rather than reactive about taxes.

Tips for Retirement Savings

  • Looking for personalized help that directly addresses your finances and your retirement goals? You can find a financial advisor to help you plan. Sometimes you need an expert opinion about what to do with your money. A matching tool like SmartAsset’s can help you find a financial advisor to work with to meet your needs. First you’ll answer a series of questions about your financial situation and goals. Then the program will narrow down your options to up to three suitable advisors in your area. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.
  • Want to calculate your specific state’s retirement income tax friendliness? Click on your state (or where you hope to retire) for details. Pro tip: Florida and Nevada are two of the most tax-friendly states for retirees. If you like the heat and saving money, you might enjoy those states.

Photo credits: ©iStock.com/Zinkevych, ©iStock.com/gece33, ©iStock.com/wutwhanfoto

Nina Semczuk, CEPF® Nina Semczuk is a Certified Educator in Personal Finance® (CEPF®) and a member of the Society for Advancing Business Editing and Writing. She helps makes personal finance accessible. Nina started her path toward financial literacy at fourteen after filling out her first W-4 and earning her first paycheck. Since then, she's navigated the world of mortgages, VA loans, Roth IRAs and the tax consequences of changing states or countries at least once a year. Nina specializes in mortgage, savings and retirement education. Nina is a graduate of Boston University and served as an officer in the military for five years. Find her work on The Muse, Business Insider, Fast Company, Forbes and around the web.
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