When you withdraw funds from your 401(k)—or "take distributions," in IRS lingo —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 your paycheck was. However, the tax burden you’ll incur varies by the type of 401(k) you have 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.
- Roth 401(k) withdrawals are not generally taxable, provided the account is five years old 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.
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 paid with pre-tax dollars, meaning they were taken "off the top" of your gross salary, reducing your taxable earned income 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 traditional IRA, another tax-deferred retirement account that's offered by some smaller employers (as a SEP-IRA) or may also be opened by an individual. Contributions to traditional IRAs are also made with pre-tax dollars, and so taxes are due on them when the money's withdrawn.
Figuring Out Your Taxes on a Traditional 401(k)
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 of 2017; however, the basic structure, comprising seven tax brackets, remains intact, as do the graduated rates. Additionally, this reduction is set to expire in 2025.
For the tax year 2019, for example, a married couple that files jointly and earns $80,000 together would pay 10% tax on the first $19,400 of income, 12% on the next $59,550, and 22% on the remaining $1,050. 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 rate makes it important to consider how 401(k) withdrawals, which are required after you turn 70½, 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 sizeable 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.
Percentage of Social Security benefits that may be taxed if your annual income exceeds $34,000 ($44,000 for married couples)
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 didn't get a tax deduction for the contribution at the time. 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.
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 variety 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 70½ (unlike Roth IRAs).
However, 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. As of the 2019 tax year, the capital gains tax rates are zero, 15%, and 20%, depending on the level of your income.
Roll Over Funds
You can also avoid taxation on your Roth 401(k) earnings 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 post-tax contributions, and 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.