How Are 401k Withdrawals Taxed?
The topic of taxation on any type of account is frequent. “How are 401k withdrawals taxed?” is one of the most common questions I’m asked. While taxes on a 401k account may seem pretty straightforward, it is anything but. The typical financial planner’s answer is, “It all depends.” It may not be the most popular answer, but it’s the right one.
Several different factors go into giving a specific answer for individual circumstances. For example:
- How are you taking money out of your 401k?
- How was your 401k funded?
- How are 401k withdrawals taxed based on those answers?
Let’s discuss a few distinctive components determining how 401k withdrawals are taxed.
Taxes in Retirement
Taxes in retirement are treated very differently than when you’re working. When working, you have federal income tax plus your Social Security and Medicare tax. If you work for somebody else as a W2 employee, that company pays part of that tax, and you pay part of that Social Security and Medicare tax. You also may have state income taxes depending on where you live.
As an employee, you probably never really considered the taxes because they are already being taken from your paycheck. The company is withholding them for you. When you file your taxes and don’t have to pay anything, it’s not a concern. You may also get $1000 or more back as a return. You’re happy but still don’t think about your assets’ taxation.
However, when it comes to retirement, you are now responsible for deciding how much to withhold. This decision often depends on where the income is coming from. If it’s coming from a 401k, it may or may not be taxed, depending on how it’s structured.
Taxable Income
Taxable income boils down to where the income is generating from. Is it coming from
- 401k account(s)
- Pension
- Social Security
- Stocks or Mutual funds
- Non-retirement accounts or annuity life insurance
If your income comes from a 401k, and it’s taxable income being added to whatever other income sources you may have, you have to pull it all together and add it up to get the new tax of your adjusted gross income. You’ll often have a standard deduction to subtract from the total. Depending on your situation, you may also have some itemized deductions.
All your income combined, less deductions or credits, will provide your total taxable income for the year. That is the number that will be taxed based on the effective rate or the effective amount you are required to pay as taxes.
When you make a 401k withdrawal, it’s often standard practice for the custodian or firm that holds the money to ask you how much you want to withhold. You can choose to withhold nothing, 20%, 30%, or more. Knowing your estimated tax bracket will help you determine the appropriate withholding amount.
How Are 401k Withdrawals Taxed?
Many people do not realize that there are different types of 401k accounts. Let’s look at the most common 401k types and how they are taxed.
Traditional 401k
A traditional 401k means you saved taxes on all the money going in. This is what a pre-tax contribution means. You contribute money to the 401k before you’re taxes are withheld. When you withdraw money from the 401k in retirement, it is considered taxable income because you did not pay taxes on the money going in.
Roth 401k
If you contributed to a Roth 401k, your withdrawal will be tax-free. Saying “tax-free” assumes you meet several different tests, such as a five-year rule, 59 ½ rule, etc. More detailed information on this is provided here.
After-Tax 401k
Think of this as a blend of the prior two. The main difference between this and the traditional 401k is that you did not receive any tax benefits on the money you contributed. The contribution was made after your tax withholding.
It’s important to differentiate between contribution and growth on this type of account. The contribution is what you put in. Growth is money earned on the account. It is considered tax-deferred, meaning you don’t pay taxes on the earnings until you take it out.
This type of account may create a scenario where the money you put in is not taxable, but the growth on that money is.
Company Stock
The last thing regarding taxation types within your 401k account is company stock. Disney, for example, has the ability to buy company stock within the 401k. There is a special tax rule specifically for company stock within a 401k plan. These stocks are treated differently than others in traditional or Roth plans.
By now, you are probably starting to see why financial planners often respond, “It depends,” to the question, “How are 401k withdrawals taxed?” The key is knowing the source of the money to understand how it’s potentially taxed.
Lump-Sum Distribution
Let’s say you have $500,000 in your 401k account. You can take it all out at once in what’s known as a lump-sum distribution. Doing so would add the entire $500,000 to your taxable income for the year. Why is that important to know?
Suppose you are in a $100,000 tax bracket and take a $500,000 full distribution of your 401k. It will bump you into a $500,000 income bracket with a higher tax rate. Whether that’s the right thing to do or not depends on your situation and what you’re trying to accomplish both in the short and long term.
If the $500,000 is in a traditional account, you will pay taxes on the entire $500,000. Of course, the Roth, after-tax, and company stock situations may also be part of the equation. All withdrawal tax roads ultimately lead to the income source and type of account. This cannot be stressed enough.
Age
You should also be mindful of your age regarding 401k withdrawals. 59 ½ is typically the magic number for 401k or IRA withdrawals. If you’re over 59 ½, generally, no additional taxes are associated with those withdrawals. However, you will potentially pay taxes if you’re under 59 ½. Sometimes, you may also have to pay a 10% penalty.
There are ways to have that penalty waived, such as
- Medical situations
- First-time Homebuying
- Leaving an employer at age 55
55 is a good age to be aware of if you are retiring early and not going to work for another company. The taxation is different because you are 55, close to retirement, and it’s the last employer you will work for.
There is also a withdrawal option called equal payments. Equal payments are a way to possibly work around the 10% tax penalty as well.
Remember, age matters when it comes to taking distributions and how they are taxed.
Rollover
One last 401k withdrawal to look at is a rollover. A rollover is moving from a 401k to another employer’s 401k or an IRA. From a tax perspective, they’re similar types of accounts.
If you have an old 401k from a previous company and you’re working with a new one, you have the ability, from a tax perspective, to move from an old 401k to a new 401k. Every company is different, so check with your current employer to see if that’s an option.
Another possibility is to move an old 401k into an IRA. IRA stands for Individual Retirement Arrangement or Individual Retirement Account. These continuing tax-deferred accounts can hold old 401k’s all within one account. This option is not considered a taxable event.
Consult a Professional
There is so much to think about when it comes to 401ks and the taxation of 401ks. Many special tax rules exist based on
- Your age
- Timing
- How the money was contributed
Talking to your financial planner, tax advisor, and attorney is best. As an experienced financial planner, I regularly help clients answer questions like these.
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