Yes, 401(k) withdrawals count as income and must be reported to the IRS.

When you reach retirement age, it is time to start making withdrawals from retirement savings plans that have been accumulating dollars over the past decades. Starting at age 59½, retirement savers can start accessing their accounts without penalty. Moreover, at age 72, retirees are mandated to start taking required minimum distributions (RMDs). Here we look at what happens when you make those 401(k) withdrawals.

Key Takeaways

  • Withdrawals made from 401(k) plans are subject to income tax at your current tax rate.
  • This is because 401(k)s are tax-deferred retirement accounts, and the deferred tax liability must be paid eventually.
  • Early withdrawals are subject to income tax as well as a 10% early withdrawal penalty.

401(k) Withdrawals

All 401(k) plan withdrawals are considered income and subject to income tax. 401(k) contributions are made with pre-tax dollars, and 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 can generate gains as the investments in the account grow in value and pay interest and dividends. But these gains are tax-deferred, meaning that your account grows tax-free—but only until you start taking money out.

Starting at age 59½, you can take money out without penalty. But all withdrawals will be subject to that deferred tax liability that was never paid when the contributions to the account were made. So, if at retirement your top income tax bracket is 24%, your withdrawals will be considered taxable income subject to up to that percentage of tax.

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 in life.

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), IRA or any other tax-deferred retirement account or annuity—that withdrawal is also subject to an extra 10% penalty tax from the Internal Revenue Service (IRS).

As a result, people who need to tap their accounts take the money as a loan, rather than an actual distribution. Since the loan is to be repaid, with interest, it doesn't trigger the penalty, nor does it considered taxable. Some 401(k) plans let you take out loans from up to 50% of your available account balance.

However, if you cannot pay back the full balance of the loan within five years, then it is considered to be a withdrawal and is subject to income tax. If you are under age 59½ at that time, then it's also considered an early distribution—and so 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 balance of the loan upon the termination of employment.

Exceptions to the Extra 10% Penalty Tax

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 concern is the health-related costs. If the amount of your unreimbursed medical expenses is more than 10% of your adjusted gross income (AGI) (7.5% if you are 65 or older) and you take a distribution from your 401(k) to cover those expenses, then the IRS exempts you.

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.