When you withdraw funds from your 401(k)—or take distributions—you begin to enjoy the income from this retirement saving mainstay and face its tax consequences. For most people, and with most 401(k)s, distributions are taxed as ordinary income. However, the tax burden you’ll incur varies by the type of account you have: traditional or Roth 401(k), and by how and when you withdraw funds from it.
- The tax treatment of 401(k) distributions depends on the type of plan: traditional or Roth.
- Traditional 401(k) withdrawals are taxed at an individual's current income tax rate.
- In general, Roth 401(k) withdrawals are not taxable provided the account was opened at least five years ago and the account owner is age 59½ or older.
- Employer matching contributions to a Roth 401(k) are subject to income tax.
- There are strategies to minimize the tax bite of 401(k) distributions.
Figuring Out Your Taxes on a Traditional 401(k)
Distributions from a regular, or traditional, 401(k) are fairly simple in their tax treatment. Your contributions to the plan were paid with pre-tax dollars, meaning they were taken off the top of your gross salary. That reduced your taxable earned income (by the amount of the contributions) and, thus, the income taxes you paid at that time. Because of that deferral, taxes become due on the 401(k) funds once the distributions begin.
Usually, the distributions from such plans are taxed as ordinary income at the rate for your tax bracket in the year you make the withdrawal. There are, however, a few exceptions, including if you were born before 1936 and you take your distribution as a lump sum. In such a case, you may qualify for special tax treatment.
The situation is much the same for a SEP IRA, another tax-deferred retirement account that's offered by some smaller employers or opened by a self-employed individual. Contributions are also made with pre-tax dollars, so taxes are due on them when the money's withdrawn.
Taxes on a Traditional 401(k)
Take the tax year 2022, for example. A married couple that filed jointly and earned $90,000 together paid $9,615 plus 22% of the amount over $83,550. (For tax year 2023, the tax owed on the same income of $90,000 will be $10,294 plus 22% of the amount over $89,450.)
If the couple's income rises enough so that they enter a higher tax bracket (or add more income to the 22% bracket), additional taxes would be owed.
That upward creep in the tax rate makes it important to consider how 401(k) withdrawals, which are required after you turn 73 (or 75 in some cases), may affect your tax bill once they're added to other income. "Taxes on your 401(k) distributions are important," says Curtis Sheldon, CFP®, president of C.L. Sheldon & Company LLC in Alexandria, Va. "But what is more important is, 'What will your 401(k) distributions do to your other taxes and fees?'"
Sheldon cites the taxation of Social Security benefits as an example. Normally, Social Security retirement benefits aren't subject to income tax unless the recipient's overall annual income exceeds a certain amount. A sizable 401(k) distribution could push someone's income over that limit, causing a large chunk of Social Security benefits to become taxable when they would have been untaxed without the distribution being made. If your annual income exceeds $34,000 ($44,000 for married couples), 85% of Social Security benefits may be taxed.
As with other income, distributions from traditional 401(k) and traditional IRA accounts are taxed on an incremental basis, with steadily higher rates for progressively higher tiers of income. Rates were reduced by the Tax Cuts and Jobs Act (TCJA) of 2017. But the basic structure, comprising seven tax brackets, remains intact, as do the graduated rates. Additionally, this reduction is set to expire in 2025.
Such an example underlines the importance of paying close attention to when and how you withdraw money from your 401(k).
Taxes on a Roth 401(k)
With a Roth 401(k), the tax situation is different. As with a Roth IRA, the money you contribute to a Roth 401(k) is made with after-tax dollars, meaning you don't get a tax deduction for the contribution at the time you make it. So, since you’ve already been taxed on the contributions, it's unlikely you’ll also be taxed on your distributions, provided your distributions are qualified.
No Taxes Owed on Qualified Distributions
For distributions to qualify, the Roth must have sufficiently "aged" (that is, been established) from the time you contributed to it, and you must be old enough to make withdrawals without a penalty. "While the designated Roth 401(k) grows tax-free, be careful that you meet the five-year aging rule and the plan distribution rules to receive tax-free distribution treatment once you reach the age of 59½," according to Charlotte A. Dougherty, CFP®, founder of Dougherty & Associates, in Cincinnati, Ohio.
One important note: These rules and restrictions apply to the money earned by your account: anything above and beyond what you deposited into it. Unlike the traditional 401(k), you can take distributions of your contributions from the Roth 401(k) at any time without penalty. The earnings, however, still need to be reported on your tax return; in fact, the entire distribution does.
Like the traditional 401(k), the terms of Roth 401(k)s stipulate that required minimum distributions (RMDs) must begin by age 73 (for people born between 1951 and 1959) and age 75 (for those born in 1960 or later). They were reinstated for tax years 2021 and on after being waived for these accounts in 2020 by the CARES Act.
Taxes Owed on Employer Matching Contributions
Your Roth 401(k) isn't completely in the clear, tax-wise. If your employer matches your contributions to a Roth, that part of the money is considered to be made with pre-tax dollars. So you will have to pay taxes on those contributions when you take distributions. They are taxed as ordinary income.
Special 401(k) Tax Strategies
For certain taxpayers, other strategies related to retirement accounts may allow a reduction in their tax bite.
Declare Company Stock a Capital Gain
Some companies reward employees with stock, and often encourage the recipients to hold those investments within 401(k)s or other retirement accounts. While this arrangement can have disadvantages, its potential pluses can include more favorable tax treatment.
Christopher Cannon, MS, CFP®, of RetireRight Pittsburgh, says, "Employer stock held in the 401(k) can be eligible for net unrealized appreciation treatment. What this means is the growth of the stock above the basis is treated to capital gain rates, not [as] ordinary income. This can amount to huge tax savings. Too many participants and advisors miss this when distributing the money or rolling over the 401(k) to an IRA."
In general, financial planners consider paying the long-term capital gains tax to be more advantageous to taxpayers than incurring income tax. For those in higher tax brackets, income tax rates are around twice those that apply for capital gains. For the 2022 and 2023 tax years, the capital gains tax rates are zero, 15%, and 20%, depending on the level of your income. (In a few specific instances the rate can be 25% or 28%.)
You can also avoid taxation on your Roth 401(k) earnings (if you don't meet the 5-year rule and are under age 59 1/2) if your withdrawal is for the purposes of a rollover. If the funds are simply being moved into another retirement plan or into a spouse's plan via direct rollover, no additional taxes are incurred. If the rollover is not direct, meaning the funds are distributed to the account holder rather than from one institution to another, the funds must be deposited in another Roth 401(k) or Roth IRA account within 60 days to avoid taxation.
In addition, an indirect rollover means that the portion of the distribution attributable to contributions cannot be transferred to another Roth 401(k) but can be transferred into a Roth IRA. The earnings portion of the distribution can be deposited into either type of account.
The Bottom Line
Managing, and minimizing, the tax burden of your 401(k) account begins with the choice between the Roth 401(k), funded by after-tax contributions, and a traditional 401(k), which receives pre-tax income. Some professionals advise holding both in order to minimize the risk of paying all the resulting taxes now or all of them later.
As with many other retirement decisions, the choice between Roth and regular accounts—if you have access to both—will depend on such individual factors as your age, income, tax bracket, and domestic status. Given the complexity of weighing those considerations, and more, it’s wise to seek professional advice.