When you withdraw funds from your 401(k)—or “take distributions,” as the lingo goes—you begin to both enjoy the income from this retirement mainstay and face its tax consequences. For most people and with most 401(k)s, distributions are taxed as ordinary income, much like a paycheck. However, the tax burden you’ll incur varies by the type of 401(k) and on how and when you withdraw funds from it.
Taxes on a Regular 401(k)
Distributions from a regular, or traditional, 401(k), are fairly simple in their tax treatment. Your contributions to the plan were tax-deferred, meaning they were made with pre-tax dollars and your income tax you paid at that time was reduced. Because of that deferral, taxes become due once the distributions begin. For most people, the distributions from such plans are taxed as ordinary income at the same rate as their other earnings. 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 treatment is much the same for a traditional IRA, a similar retirement account that's offered by some smaller employers or may also be opened by an individual. Contributions to traditional IRAs, which are also made with pre-tax dollars, are taxed at distribution.
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. As of the 2018 tax year, rates were reduced by the Tax Cuts and Jobs Act of 2017; however, the basic structure, comprising seven tax brackets, remains intact. For example, a married couple that files jointly and together earns $80,000 would pay 10% tax on the first $13,600 of income, 12% on the next $38,200, and 22% on the remaining $28,200. If the couple’s income rose, enough that it entered the next tax bracket, some of the additional income could be taxed at the next highest incremental rate of 24%.
That upward creep in the tax bite makes it important to consider how 401(k) distributions, which are required after you turn 70, 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, Virginia. "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. By increasing taxable income for the year, a 401(k) distribution could cause a large chunk of Social Security benefits to become taxable, when they would have been untaxed without the distribution being made.
Such an example underlines the importance of paying close attention to when and how you withdraw money from your 401(k). For one, there are consequences to withdrawing funds early. If you make distributions when you’re younger than 59½, you will pay a 10% penalty for early withdrawal, above and beyond what you will owe in income tax.
Taxes on a Roth 401(k)
As with a Roth IRA, the money you contribute to a Roth 401(k) is taxed before your contribution. 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.
For distributions to qualify, the Roth must have sufficiently “aged” 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.
Additionally, if your employer matches your contributions to a Roth, that part of the money is considered to be pre-tax; you will have to pay taxes on those contributions when you take distributions. However, unlike the traditional 401(k), you can take distributions of your contributions at any time without penalty. The earnings, however, still need to be reported on your tax return.
Special Tax Strategies
For certain taxpayers, other strategies related to retirement accounts may allow a reduction in their tax burden.
Declare stock income as 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, M.S., 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. As of the 2018 tax year, the capital gains tax rates are zero, 15% and 20%, depending on the level of your income.
Make charitable contributions from your traditional IRA
As of the 2018 tax year, it became a better bet in tax terms for many people to stop itemizing their tax returns, due to a higher standard deduction and the $10,000 cap on local and state tax deductions. In addition, filers who don’t itemize generally don’t receive a tax-reducing benefit from their charitable giving.
However, your IRA may allow you to continue a tax benefit for contributing to charity, even if you don’t itemize. Anyone 70½ or older may make a direct transfer of IRA balances up to $100,000 per year to a charitable organization. If you take the money out of a traditional IRA, this qualified charitable distribution will count toward your required minimum distribution and keep that RMD amount from adding to your taxable income. (Note that Roth IRAs don't require RMDs during the account owner's lifetime, so taking charitable contributions from a Roth has no positive tax consequences unless you itemize your taxes.)
To qualify for such treatment, however, charitable donations are allowed only from IRAs,and not from 401(k)s. Still, “if you are a high-income earner, consider using charitable-planning strategies to strategically convert taxable retirement accounts to tax-free,” says Carlos Dias Jr., who is a wealth manager of Excel Tax & Wealth Group in Lake Mary, Florida.
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 post-tax contributions, or a traditional 401(k), which receives pre-tax income. Some professionals advise holding both a Roth 401(k) and a traditional 401(k) 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 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.
A host of strategies, some little known, could lower your tax burden from those accounts, and a tax professional or financial planner can help you navigate through them. Consider hiring a fee-only financial advisor to minimize the likelihood that the choices they recommend will be influenced by their relationship to certain companies, rather than your needs.