One of the most attractive features of a 401(k) plan is that you can contribute pretax dollars throughout your career. This reduces your taxable income and allows you to contribute more to your retirement with each paycheck. That said, you’re only postponing taxation, not avoiding it entirely. You’ll still have to pay taxes on that money once you start withdrawing it. If you need to plan your 401(k) withdrawals, you should consider working with a financial advisor.
The Basics of 401(k) Withdrawal Taxes
If you are wondering whether your 401(k) withdrawals are taxed, the short answer is yes – your 401(k) distributions are likely taxable.
This may come as a surprise because there is some confusion about how retirement accounts work. People often refer to retirement accounts like 401(k)s as tax-advantaged or tax-deferred. This means investments within your 401(k) or 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.
As an example, if you earn $1,500 per paycheck before taxes and you contribute $300 of that money to your 401(k), then you will only be taxed on $1,200. You should note that there are limits to how much you can contribute to your 401(k) each year. For 2024, the limit is $23,000, and $30,500 for those 50 and older. For 2023, the limit is $22,500, and $30,000 for savers 50 and older.
This tax advantage, however, changes once an account holder starts receiving distributions from the 401(k). As you pull money out, you’ll owe income 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 59.5 you can withdraw money from your 401(k). If you don’t need the money yet, you can wait until you reach age 73 (75 in 2033) to withdraw funds. However, once you reach 73, 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.
Do you need help figuring out your required minimum distributions? Try SmartAsset’s RMD calculator to learn more.
The exception is if you have a Roth 401(k). Like with a Roth IRA, money is put into these accounts after taxes, so the distributions are generally untaxed.
401(k) Tax Rates
Your 401(k) withdrawals are taxed as income. There isn’t a separate 401(k) withdrawal tax. Any money you withdraw from your 401(k) is considered income and will be taxed as such, alongside other sources of taxable income you may receive. As with any taxable income, the rate you pay depends on the amount of total taxable income you receive that year. 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. (Some states are more tax-friendly to retirees.)
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.
401(k) Withdrawal Taxes and Early Distributions
You might find yourself in a situation where you need the money in your 401(k) before you reach 59.5 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. 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 opportunity cost of pulling your investments out of the market.
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 substantially equal periodic payments) plan are two examples. You’ll still be on the hook for income taxes, of course.
Given the tax hit and the opportunity cost of early withdrawals, it’s not an ideal solution. Before you commit to a penalized withdrawal, consider if borrowing the money from your 401(k) might be a better solution.
401(k) Withdrawal Taxes: How to Minimize Them
You won’t be able to get out of paying taxes on the funds you withdraw from your 401(k). However, there are a couple of tips and tricks that might help you lower the total tax you pay. Be sure to check with a tax expert or financial advisor if you want to be sure of the best course of action for your specific situation.
If you happen to hold stock in your company within your 401(k) account, you could potentially treat the appreciation of that stock as a capital gain rather than ordinary income. The long-term (over a year) capital gain tax rate is 0%, 15% or 20%, depending on your tax bracket. For many investors, this means a lower tax rate than their ordinary income tax rate. To pull this off, you’ll need to transfer the stock into a taxable brokerage account. Don’t be afraid to consult with an expert if you want to take advantage of this strategy.
The other factor to consider is your tax bracket. If your 401(k) distributions will put you in the lower end of one tax bracket, see if you can start distributions earlier, spreading things out and potentially dropping you into a lower bracket. As long as you start after age 59.5, you could save on your total tax bill with this method.
Bottom Line
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 know your tax bill. It’s always better to be proactive rather than reactive about taxes.
Tips for Retirement Savings
- A financial advisor can help you create a financial plan for your retirement needs and goals. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Start saving for retirement early. No matter which retirement savings account you settle on, it’s always better to start saving sooner than later. The sooner you invest your money, the more time you have to reap the benefits of compound interest. This can have a big impact on your retirement savings.
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