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When you withdraw funds or take distributions from your 401(k) in retirement, you begin to enjoy new income but you must also face its tax consequences. Distributions are taxed as ordinary income but the tax burden you’ll incur varies by the type of account you have: a traditional 401(k) or a Roth 401(k). It also depends on when you withdraw funds from your account.
Key Takeaways
- The tax treatment of 401(k) distributions depends on whether it’s a traditional or Roth plan.
- Traditional 401(k) withdrawals are taxed at the account owner’s current income tax rate.
- Roth 401(k) withdrawals generally aren’t taxable, provided the account was opened at least five years ago and the account owner is age 59½ or older.
- Employer matching contributions to a Roth 401(k) are subject to the account owner’s income tax rate.
Traditional 401(k) Contributions
Contributions to a traditional 401(k) are paid with pre-tax dollars. They are taken off the top of your gross salary, reducing your taxable earned income by the amount of the contributions and therefore reducing the taxes you pay that year. Taxes on your 401(k) funds therefore come due when you withdraw the money in retirement.
The distributions from these plans are usually taxed as ordinary income at the rate for your tax bracket in the year you make the withdrawal. You may qualify for special tax treatment, however, if you were born before Jan. 2, 1936 and you take your 401(k) as a lump sum.
Note
The situation is much the same for a SEP IRA, another tax-deferred retirement account that’s offered by some smaller employers or opened by a self-employed individual. Contributions are made with pre-tax dollars so taxes come due on this money when it’s withdrawn. The earnings grow tax-free, however, subject to some qualifying rules.
Taxes on a Traditional 401(k)
Let’s say a married couple files a joint tax return. They earn $90,000 together. They take their standard deduction. They make no other adjustments so their taxable income is $60,000. The tax they’ll owe will be based on their effective tax rates. They may owe additional taxes if their income rises enough to push them into a higher tax bracket than normal.
It’s therefore necessary to consider how 401(k) withdrawals that are required after age 73 or age 75 if you turn 74 after Dec. 31, 2032 could affect your tax bill when you add in your 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.
Social Security retirement benefits aren’t subject to income tax unless the recipient’s overall annual income exceeds a certain amount. A sizable 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 had the distribution not been made.
Important
A substantial portion of your Social Security benefits could taxed if your annual income including those benefits exceeds the allowed limit for married couples.
Distributions from traditional 401(k) and traditional IRA accounts are taxed incrementally like other income. Steadily higher rates apply to progressively higher income tiers. Rates were reduced by the Tax Cuts and Jobs Act (TCJA) of 2017.
How Roth 401(k)s Are Taxed
The tax situation is different with a Roth 401(k). The money you contribute to a Roth 401(k) is made with after-tax dollars, just as it is with a Roth IRA. You don’t get a tax deduction for the contribution at the time you make it. You’ve already been taxed on your contributions so you likely won’t be taxed on your distributions provided your distributions are qualified.
No Taxes on Qualified Distributions
Two factors determine whether a distribution is qualified. The Roth account must have been established at least five years ago 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,” says Charlotte Dougherty, CFP, founder of Dougherty & Associates in Cincinnati, Ohio.
Taxes Owed on Employer Matching Contributions
Your Roth 401(k) isn’t completely in the clear tax-wise. You must pay taxes on the money when you make withdrawals in retirement if your employer matches your Roth account contributions. These matches are taxed as ordinary income.
Special 401(k) Tax Strategies
Certain strategies may result in a less painful tax bite for some taxpayers.
Declare Company Stock a Capital Gain
Some companies reward employees with stock and encourage the recipients to hold those investments within their 401(k)s or other retirement accounts. This arrangement can have disadvantages but it can also mean more favorable tax treatment.
Christopher Cannon, MS, CFP, owner of RetireRight Financial Planning, 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.”
Financial planners generally consider paying the long-term capital gains tax to be more advantageous than incurring income tax. The capital gains tax rates are typically 0% and 15% depending on your income. However, individuals and couples making more than a certain annual limit will owe a 20% long-term capital gains tax.
There are a few exceptions. The capital gains tax rate can be 25% or 28% for transactions such as those involving certain types of real estate and collectibles.
Rollover Funds
Even if your Roth account doesn’t meet the five-year rule and/or you’re under age 59½, you can still avoid taxation on your Roth 401(k) earnings. Just make sure your withdrawal is for a rollover. No additional taxes are incurred if your funds are being moved into another retirement plan or a spouse’s plan via a direct rollover.
If the rollover isn’t direct, the funds distributed to the account holder must be deposited into another Roth 401(k) or Roth IRA account within 60 days to avoid taxation.
How Much Will My 401(k) Be Taxed When I Retire?
It depends on whether you have a Roth or a traditional 401(k). Your entire withdrawal including contributions and earnings will be taxed as income if you have a traditional 401(k). These distributions are taxed like the money you earn from a job.
You can take tax-free distributions from a Roth 401(k) tax-free if you’re 59½ or older and it’s been at least five years since your first deposit into the account. You already paid taxes on those contributions at the time you made them with a Roth account.
Any employer matching contributions to a Roth account are treated like a traditional account, however. You’ll have to pay taxes on those distributions when you withdraw the funds in retirement.
At What Age Is My 401(k) Not Taxed?
Age 59½ or older is when you can take distributions from a 401(k) without the 10% early withdrawal penalty. A traditional 401(k) withdrawal is taxed at your income tax rate. A Roth 401(k) withdrawal is tax-free.
What’s the 4% Rule for Retirement Taxes?
The 4% rule is a traditional method for estimating how much you can withdraw from an account for a sustainable retirement that lasts at least 30 years or so. It’s a way to ensure that you don’t run out of funds when you’re retired. A couple with a $2 million nest egg could safely withdraw $80,000 per year in retirement using the 4% rule.
The Bottom Line
Managing and minimizing the tax burden of your 401(k) begins with the choice between a Roth 401(k) that’s funded with after-tax contributions and a traditional 401(k) that receives pre-tax income. Some professionals advise holding both types of plans to minimize the risk of paying all the resulting taxes now or paying all of them later.
The choice between Roth and regular accounts will depend on individual factors such as your age, income, tax bracket, and whether you’re married. It’s wise to seek professional advice from a fiduciary given the complexity of weighing those considerations. Fiduciary advice providers must act in their client’s best interests, avoid misleading statements, and charge only reasonable fees for their services under the terms of the Retirement Security Rule.
