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401(k) withdrawals count as income and must be reported to the Internal Revenue Service (IRS). Starting at age 59½, retirees can begin accessing 401(k) funds without an early-withdrawal penalty. At age 73 (for individuals born between 1951 and 1959) or age 75 (for those born in 1960 or later), retirees must start taking required minimum distributions (RMDs).
Key Takeaways
- Withdrawals made from 401(k) plans are subject to income tax at your effective tax rate.
- During the years that they contribute to a traditional (non-Roth) 401(k), retirement savers enjoy a lower taxable income.
- Early withdrawals are subject to income tax and a 10% early withdrawal penalty, unless they qualify as hardship withdrawals.
401(k) Withdrawals
All traditional (non-Roth) 401(k) plan withdrawals are considered income and subject to income tax, because traditional 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 the same way, whether or not it’s a Roth 401(k).
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 your withdrawals will be considered taxable income subject to your effective tax rate.
The idea behind tax-deferred retirement savings is that a person’s income tax bracket will likely 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. The one catch: you must have had your account for at least five years.
Note that withdrawals from Roth 401(k)s are treated differently. Contributions are made with post-tax dollars, thus, withdrawals during retirement are tax-free.
Early Withdrawals
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 IRS.
There are ways to avoid the early withdrawal penalty. For example, 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.
401(k) Loans
401(k) loans are not considered income for income tax purposes. 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. Most 401(k) plans 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, as well.
Another instance in which a 401(k) loan becomes a taxable withdrawal is if you cannot pay back the remaining loan balance upon termination of employment at the company where you had the plan and fail to roll the offset amount over into another retirement plan before the due date.
401(k) Rollovers
401(k) rollovers are not taxable, as long as they are rolled over to a traditional IRA or traditional 401(k). Rolling over a traditional 401(k) to a Roth IRA means the funds will be taxable.
Note that if you do an indirect rollover, where your plan administrator sends you the funds directly, you have 60 days to deposit it into a rollover account or face the 10% early withdrawal penalty. A direct rollover is often simpler, where your plan administrator will handle the transfer of money to a new plan or IRA.
Is a 401(K) Withdrawal Considered Earned Income or Capital Gains?
Traditional 401(k) withdrawals are considered income (regardless of your age). However, you won’t pay capital gains taxes on these funds.
Does a 401(K) Withdrawal Count As Adjusted Gross Income?
Do 401(K) Withdrawals Count as Income Against Social Security?
401(k) withdrawals don’t count as income for determining your Social Security benefits. However, they could boost your income to the point that you are in a higher tax bracket, meaning your Social Security benefits are taxed at a higher rate.
The Bottom Line
Withdrawals from 401(k)s are considered income and are generally subject to income taxes because contributions and gains 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.