When you reach retirement age, it's time to start withdrawals from retirement savings plans that have been accumulating dollars over the decades. And yes, 401(k) withdrawals count as income and must be reported to the Internal Revenue Service (IRS).

Starting at age 59½, retirement savers can start accessing their accounts without penalty. At age 72, retirees are mandated to start taking required minimum distributions (RMDs). What happens with your taxes when you make those 401(k) withdrawals?

Key Takeaways

  • Withdrawals made from 401(k) plans are subject to income tax at your effective tax rate.
  • During the years that they contribute, retirement savers enjoy a lower taxable income.
  • Early withdrawals are subject to income tax and potentially a 10% early withdrawal penalty.

401(k) Withdrawals

All 401(k) plan withdrawals are considered income and subject to income tax because 401(k) contributions are made with pretax dollars. As a result, retirement savers enjoy a lower taxable income in the years that they contribute. Employer matches are also treated in the same way.

Once these dollars are invested in the 401(k) plan, they generate gains as the investments in the account grow in value and pay interest and dividends. These gains are tax-deferred, meaning that your account grows tax-free. That freedom from taxes ends when you begin taking out money.

Starting at age 59½, you can take money out without penalty but withdrawals will be subject to that (deferred) tax liability you never paid when you contributed to the account. So if at retirement your top income tax bracket is 24%, your withdrawals will be considered taxable income subject to your effective tax rate. 

On March 27, 2020, former President Donald Trump signed a $2 trillion coronavirus emergency stimulus bill. It allows those affected by the coronavirus situation a hardship distribution to $100,000 without the 10% penalty those younger than 59½ normally owe. Account owners have three years to pay the tax owed on withdrawals, instead of owing it in the current year. Or, they can repay the withdrawal to a 401(k) or IRA plan and avoid owing any tax—even if the amount exceeds the annual contribution limit for that type of account.  

The idea behind tax-deferred retirement savings is that a person's income tax bracket should be lower at a phase in life when regular employment income has slowed or ceased than when they are working and making contributions. So instead of paying higher tax rates now, you defer those taxes (and all of the growth that has occurred in the account as well) until you hit that lower tax bracket later.

Contributions to a Roth 401(k) come from after-tax dollars, and so withdrawals from the account are actually tax-exempt instead of just tax-deferred.

Premature Distributions and Loans

When you take a premature distribution—a withdrawal before age 59½ from a 401(k), individual retirement account (IRA), or any other tax-deferred retirement account or annuity—that withdrawal is also subject to an extra 10% penalty from the Internal Revenue Service (IRS).  As a result, people who need to tap their accounts often take the money as a loan rather than as an actual distribution.

Since the loan is to be repaid, with interest, it doesn't trigger the penalty, nor is it considered taxable. Most 401(k)s allow you to take out loans up to the lesser of $50,000 or 50% of the account balance.

If you can't pay back the full balance of the loan within five years, it is considered a withdrawal and is subject to income tax. If you are younger than 59½ at that time, it's also considered an early distribution and becomes subject to the 10% penalty fee, as well. Another instance in which a 401(k) loan becomes a taxable 401(k) withdrawal is if you cannot pay back the remaining loan balance upon termination of employment at the company where you had the plan.

Exceptions to the Penalty

While all 401(k) distributions are subject to income tax, there are several exceptions to the extra 10% penalty tax. One is if you roll over the funds into another qualified retirement plan.

Another is if the amount of your unreimbursed medical expenses is more than 7.5% of your adjusted gross income and you take a distribution from your 401(k) to cover those expenses.

When you take a loan from your 401(k), you might open a separate checking account to deposit the withdrawal and make the medical payments. By keeping a detailed paper trail of the use of your 401(k) funds, you can be ready in case of an audit.

The Bottom Line

Withdrawals from 401(k)s are considered income and are generally subject to income tax because contributions and growth were tax-deferred, rather than tax-free. Still, by knowing the rules and applying withdrawal strategies you can access your savings without fear. If you have questions, check with a tax expert or financial advisor.