How do taxes on 401(k) withdrawals work?
If a lump-sum 401(k) withdrawal was taxed at the time of withdrawal, is that amount added to the entire annual income figure when filing federal taxes? If it is, it seems like it is being taxed twice. How do taxes on 401(k) withdrawals work?
The amount you withdraw from a 401(k) will be taxed as ordinary income for the year you make the withdrawal. If you're under age 591/2 at the time of withdrawal you could be subject to the 10% penalty on top of paying ordinary income as well.
It's not being taxed twice because when you contributed to the 401(k) the amount wasn't being included in your taxable income. The contributions were being "tax-deferred" until withdrawal. The major benefit of tax-deferral is it allows the funds to be invested and re-allocated while they're in the 401(k) without having to pay taxes.
On the other hand, Roth 401(k) withdrawals are tax-free, meaning you don't add the amount to your ordinary income in the year you make withdrawals. That's because you ALREADY paid taxes on the contribution amounts.
With a 401k, it is mandatory for the 401k provider/administrator/company withhold 20% & send directly the IRS (Treasury) regardless of what your actual marginal tax. This will be "netted" against your actual taxes owed & taxes paid. So assuming your marginal tax rate is really only 10%, you will get a refund at the end of the year for the difference but you gave the IRS an interest free loan for that period. Conversely, if you underpay your taxes, they hit you with interest and penalties. Also, if you are under 59 1/2 there is a 10% penalty for early withdraw unless you qualify to one of the few exceptions to pay the penalty.
Point is, the mandatory withholding is a rough estimate of the taxes owed just like the withholdings on your paycheck. Then you either owe more at the end of or get a refund at year-end. The refund is your own money back after a free loan to the IRS. So it is important to try to estimate withholdings as closely as possible.
Now if you are retired, you should probably "roll" your 401k assets directly into an IRA Rollover. With an IRA, you can set your own withholding rate - 20%, 15%, 8%, or even 0% - to better match your actual circumstances. And you could simply do a partial withdraw for what you need rather than a lump-sum. You will also have virtually unlimited investment choices and a lower fee structure going forward. Thus a lump-sum withdraw from a 401k is the worst case scenario with the highest costs & least control.
Hope this helps and best of luck, Dan Stewart CFA®
No, you are not taxed twice. The tax liability arises at the time the withdrawal is made, but payment is not due until annual returns are filed. The withdrawal amount is added to the rest of your annual income when filing your returns. This is essentially the same as withdrawals from other types of tax-deferred acounts, such as IRAs. Indeed, for IRA holders who have already reached 70 1/2, there is an annual required minimum distribution. The distribution can be taken any time during the year, but the tax payment is not due until the following year, when returns are filed and taxes are paid.
You are correct, the amount of the withdrawal is added to your annual income figure when filing for federal taxes. However, you will not be taxed twice because you will receive a credit for the taxes that you already paid at the time of the withdrawal.
Thank you for submitting your question about taxes on 401(K) withdrawals. You will be taxed for taking a withdrawal, but not twice. If you reinvest the funds in an investment account that generates a positive return and you later sell the investment for a profit, then you will be taxed again. There is an option where you may deposit funds that you previously withdrew from a 401(K) plan that would allow you to receive tax deferred growth and tax free withdrawals. I have written about this sort of option in the past, in a blog post entilted, "Convert Required Minimum Distributions Into Tax Free Income." While I am not recommending this to you as a "suitable alternative", I believe that the knowledge alone may still be helpful.
Thanks again for submitting your question.