Most 401(k) plans are tax-deferred, which means there is no income tax on contributions or earnings until the owner decides to withdraw it. However, a Roth 401(k) is a little different. In a Roth 401(k), the contributions are taxed, and the withdrawals are tax-free. In either case, no taxes are applied on investment gains, interest, or dividends for both – traditional 401(k) and Roth 401(k) accounts until it is time to take a distribution. This makes 401(k) a great tool to save for retirement and lower the tax bill.
But there are a few rules about 401(k) and taxes and a few strategies that you need to know to lower the impact of tax on 401(k) withdrawals. Here’s an overview:
How does 401(k) withdrawal affect the tax return?
As mentioned earlier, the tax implications for a traditional 401(k) and Roth 401(k) are different.
Traditional 401(k): Contributions and earnings are tax-deferred. But your 401(k) withdrawals will be taxed as ordinary income. You’ll have to report the taxable part of your distribution directly on Form 1040.
Roth 401(k): Contributions to a Roth 401(k) are made with after-tax dollars. However, Roth 401(k) withdrawals and income earned– interest, capital gains, or dividends – are tax-free.
Are 401(k) contributions tax-deductible?
Are 401(k) contributions taxed? Yes, contributions to traditional 401(k) plans are made on pre-tax dollars, thus removing them from your taxable income and reducing the taxes you’ll pay for the year.
Unlike a traditional 401(k), contributions to a Roth 401(k) when subtracted from the paycheck have no effect on your taxable income. This means you are paying taxes on your contributions and hence won’t be paying taxes when you make withdrawals.
How much tax do I pay on a 401(k) withdrawal?
401(k) withdrawals at retirement:
- If you withdraw from a traditional 401(k), the money you withdraw is taxable as regular income, and the tax amount you pay is based on your tax bracket.
- If you withdraw from a Roth 401(k), you won’t owe any taxes at all because you have already paid the taxes upfront.
Early 401(k) withdrawals:
For traditional 401(k)s, if you withdraw money early before age 59½:
- 20% of the withdrawn amount will be held as tax.
- 10% of the withdrawn amount will be charged as a penalty.
- You’ll have less money for the future when you need it the most.
For a Roth 401(k), you need to have held the account for at least five years for the 401(k) withdrawals to be penalty-free and have attained the age of 59.5
FAQs
When can you start withdrawing from 401(k)?
You can start making penalty-free withdrawals from your 401(k) after age 59 ½.
Can I make a 401(k) lump-sum withdrawal?
Yes, you can. A 401(k) lump sum withdrawal will give you immediate access to a big chunk of money, but you will have to pay income taxes on the entire amount.
How can I avoid paying taxes on my 401(k) withdrawal?
The best ways to avoid taxes on 401(k) withdrawals are:
- Rollover your 401(k) without tax withholding.
- Donate your IRA distribution to charity
- Avoid two distributions in the same year.
- Remember required minimum distributions.
- Avoid the early withdrawal penalty.
When can you withdraw from 401(k) without paying taxes?
You can make penalty-free withdrawals after age 59 ½. The IRS forces you to make Required Minimum Distributions (RMDs) after age 72.5 (changed due to the SECURE Act passed in January) and SECURE ACT TWO will raise the age to 73 come January 2022 and then up to 75 by 2028. The house has passed SECURE ACT TWO (sometimes called Son of SECURE ACT) but has not been passed by the Senate as of this writing.
How does cashing out 401(k) affect tax returns?
Cashing out 401(k) before you reach age 59½ triggers income tax as the amount is considered as taxable income. In addition, you will have to pay a 10% early withdrawal penalty. It should be viewed as a last resort to access your money because you are giving the gov’t between 30 – 40% just to access your own money.
How much do you get penalized for taking out 401(k)?
If you withdraw money from your traditional 401(k) account before age 59½, you will have to pay income tax on the distribution and also a 10% early withdrawal penalty.
Do you get taxed twice on 401(k) withdrawal?
No, you do not pay the same tax twice on your 401(k) withdrawal. When 20% of the withdrawn amount is withheld, you’re essentially paying part of your taxes upfront.
How much will I lose if I cash out my 401(k)?
If you cash out your 401(k), 20% of the amount will be withheld to cover taxes, and a 10% withdrawal penalty will be applied. That means your plan administrator will send you a check for 70% of your 401(k) balance but your personal situation could possibly make for higher taxes when you file.
Do I have to claim 401(k) withdrawal on my taxes?
401(k) contributions are made with pre-tax dollars. Hence, they are not included in your taxable income. However, if you make a 401(k) withdrawal, then you must report the withdrawal on your tax return so that the correct amount of tax can be paid.
How to report 401(k) withdrawal on a tax return?
To report 401(k) early withdrawal, you need to complete Form 5329 with your tax return. You’ll need to report the amount of the withdrawal, whether it was exempted from a penalty, and the additional tax you owe because of the early withdrawal.
Does 401(k) withdrawal affect Social Security?
No. Since Social Security benefits are considered non-wage income, your 401(k) won’t have any impact on your Social Security.
Depending on which tax bracket you fall in, the amount withheld might or might not be enough to cover your full tax liability. If it’s not enough, you will have to pay the rest of the tax when you file your return. If the withheld tax is more than what you are liable to pay, you will get the extra money back.
Do you pay social security tax on 401(k) withdrawals?
When you start taking distributions from your 401 (k), it means that you paid your dues during your working years. Therefore, you won’t owe Social Security tax on the distribution.
Need help with 401(k) distribution taxes or other retirement account questions? Contact us for expert advice.
Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning company based in Goodyear, AZ. He has over three decades of experience working with investments and retirement planning, and over the last ten years has turned his focus to self-directed ira accounts and alternative investments. If you need help and guidance with traditional or alternative investments, call him today (866) 639-0066.
