In retirement, when you withdraw funds—or take distributions—from your401(k), you begin to enjoy new income, yet you also must face its tax consequences. Traditionally, 401(k) distributions are taxed asordinary income. However, the tax burden you’ll incur varies by the type of account you have—a traditional 401(k) or a Roth 401(k)— and by when you withdraw funds from your account.
Key Takeaways
- The tax treatment of 401(k) distributions depends on the type of account: traditional or Roth.
- Traditional 401(k) withdrawals are taxed at the account owner's current income tax rate.
- In general, Roth 401(k) withdrawals are not 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.
- There are strategies to minimize the tax bite of 401(k) distributions.
Figuring Out Your Traditional 401(k) Taxes
With a traditional 401(k), your contributions are paid with pre-tax dollars, meaning they were taken off the top of your gross salary. That reduces your taxable earned income by the amount of the contributions and, thus, the income taxes you pay that year. Because of that deferral, taxes become due on the 401(k) funds once you make withdrawals (take distributions) in retirement.
Usually, the distributions from such plans are taxed asordinary incomeat the rate for your tax bracket in the year you make the withdrawal. However, if you were born before January 2, 1936 and you take your 401(k) as a lump sum, you may qualify for special tax treatment.
The situation is much the same for aSEP 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 Contributions are made with pre-tax dollars, so taxes are due on them when the money's withdrawn. The earnings, however, grow tax-free.
Taxes on a Traditional 401(k)
Take tax year 2023, for example. A married couple filesjointly. They earned $90,000 together. They take the standard deduction ($27,700) and make no other adjustments, making their taxable income $62,300.
They pay $7,036 in federal taxes. That's (10% x $22,000) + [12% x ($62,300-$22,000)], due to how effective tax rates work.
If their income rises enough so that they enter a higher tax bracket—or add more income to the bracket they're in—they'd owe additional taxes. (For tax year 2024, if their circ*mstances didn't change, they would be in the same tax bracket.)
It's important to consider how 401(k) withdrawals, which are required after age 73 (or, if you turn 74 after December 31, 2032, it's age 75), may affect your tax bill once they're added to your other income.
"Taxes on your 401(k) distributions are important," saysCurtis Sheldon, CFP®, president ofC.L. Sheldon & Company LLC in Alexandria, Va. "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 without the distribution being made. If your annual income exceeds $34,000 ($44,000 for married couples), up to 85% of your Social Security benefits may be taxed.
As with other income, distributions from traditional 401(k) and traditional IRA accounts are taxed on an incremental basis, with steadily higher rates for progressively higher tiers of income. Rates were reduced by theTax Cuts and Jobs Act (TCJA) of 2017. But the basic structure, comprising seven tax brackets, remains intact, as do the graduated rates. This reduction is set to expire after 2025.
Taxes on a Roth 401(k)
With a Roth 401(k), the tax situation is different.As with a Roth IRA,the money you contribute to aRoth 401(k)is made with after-tax dollars, meaning you don't get a tax deduction for the contribution at the time you make it. Since you’ve already been taxed on the contributions, you likely won't be taxed on your distributions, provided your distributions are qualified.
No Taxes Owed on Qualified Distributions
There are two factors that determine whether a distribution is qualified. First, the Roth account must have been established five years ago. Second, you must be old enough to make withdrawals without a penalty.
"While the designated Roth 401(k) grows tax-free, be careful that youmeet the five-year aging ruleand the plan distribution rules to receive tax-free distribution treatment once you reach the age of 59 ½," says Charlotte Dougherty, CFP®, founder ofDougherty & Associates in Cincinnati, Ohio.
Like with traditional 401(k)s, Roth 401(k)s were previously subjected to required minimum distributions (RMDs). However, the rules have changed. Though RMDs are in place for designated Roth accounts in a 401(k)for 2023, for 2024 onward, they're not. You no longer need to take RMDs from a Roth account.
Taxes Owed on Employer Matching Contributions
Your Roth 401(k) isn't completely in the clear, tax-wise. If your employer matches your Roth account contributions, you'll need to pay taxes on those employer contributions when you make withdrawals in retirement. They are taxed as ordinary income.
Special 401(k) Tax Strategies
For certain taxpayers, these other strategies may mean a less painful tax bite.
Declare Company Stock a Capital Gain
Some companies reward employees with stock, and encourage the recipients to hold those investments within 401(k)s or other retirement accounts. While this arrangement can have disadvantages, it can also mean more favorable tax treatment.
Christopher Cannon, MS, CFP®, owner ofRetireRight Financial Planning, says, "Employer stock held in the 401(k) can be eligible fornet unrealized appreciationtreatment. What this means is the growth of the stock above the basis is treated tocapital gainrates, 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."
In general, financial planners consider paying the long-termcapital gains tax to be more advantageous to taxpayers than incurring income tax. The capital gains tax rates are typically 0% and 15%, depending on your income. Individuals and couples making more than $492,300 and $553,850, respectively, will pay a 20% capital gains tax. And there are a few exceptions. In a few types of transactions, such as certain types of real estate and collectibles, the capital gains rate can be 25% or 28%.
Rollover Funds
If your Roth account doesn't meet the 5-year rule and/or you are under age 59 1/2, you can still avoid taxation on your Roth 401(k) earnings if your withdrawal is for the purposes of a rollover. If your funds are simply being moved into another retirement plan or, for example, into a spouse's plan via a direct rollover, no additional taxes are incurred. If the rollover is not direct—the funds are distributed to the account holder, rather than from one institution to another—then the funds must be deposited in 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?
This depends on whether you have a Roth or traditional 401(k). With a traditional 401(k), your entire withdrawal (contributions and earnings) will be taxed as income. These distributions are taxed like the money you earn from a job. With a Roth 401(k), you can take distributions tax-free, as long as you're 59 ½ or older and it's been at least five years since your first deposit in the account. (This is because with a Roth account, you already paid taxes on those contributions when you made them.) However, any employer matching contributions to a Roth account are treated like a traditional account, so you'll need to pay taxes on those distributions when you withdraw those funds in retirement.
At What Age Is Your 401(k) Not Taxed?
Age 59 ½ 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 Is 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 you don't run out of funds when you're retired. Using the 4% rule, a couple with a $2 million nest egg could safely withdraw $80,000 per year in retirement.
The Bottom Line
Managing and minimizing the tax burden of your 401(k) begins with the choice between the Roth 401(k), which is funded by after-tax contributions, and a traditional 401(k), which receives pre-tax income. Some professionals advise holding both in order to minimize the risk of paying all of the resulting taxes now, or all of them later.
As with many other retirement decisions, the choice between Roth and regular accounts—if you have access to both—will depend on such individual factors as your age, income, tax bracket, and whether you are married. Given the complexity of weighing those considerations and more, it’s wise to seek professional advice.
