Are 401(k), IRA, and Roth IRA Withdrawals Subject to Tax?

The tax treatment of withdrawals from retirement accounts like 401(k)s and IRAs depends on whether contributions were made pre-tax or post-tax. This distinction determines your tax liability when you access the funds in retirement. The rules for distributions vary significantly between traditional and Roth versions of these plans.

Taxing Withdrawals from Pre-Tax Accounts

Accounts funded with pre-tax dollars, such as a traditional 401(k) or a traditional IRA, offer a tax deduction on contributions. This means the money goes into your account before income taxes are calculated, reducing your current taxable income. The investments within the account then grow on a tax-deferred basis, meaning you do not pay taxes on the earnings each year.

Withdrawals from these pre-tax accounts are taxed as ordinary income. The entire amount you withdraw, which includes both your original contributions and all investment earnings, is added to your income for that year. For example, if you are in a 22% federal tax bracket and withdraw $50,000, you will owe $11,000 in federal income tax on that distribution, plus any applicable state taxes.

The situation is more complex if you have made non-deductible contributions to a traditional IRA. Because you have already paid tax on this money, creating what the IRS calls a “basis,” it is not taxed upon withdrawal. However, the earnings are still taxable, and you cannot withdraw only your non-taxable basis first. The pro-rata rule requires that each withdrawal consists of a proportional mix of your non-deductible contributions and tax-deferred earnings, a calculation made using IRS Form 8606.

Taxing Withdrawals from Post-Tax Accounts

Retirement accounts funded with post-tax dollars, namely Roth IRAs and Roth 401(k)s, do not provide an upfront tax deduction on contributions. Instead, qualified distributions from these accounts are completely free from federal income tax. This includes both your original contributions and all the accumulated investment earnings.

For a withdrawal to be a “qualified distribution,” two conditions must be met. First, the Roth account must have been open for at least five tax years. Second, you must have a qualifying reason for the withdrawal, such as reaching age 59½, becoming permanently disabled, or the distribution being made to a beneficiary after your death.

If you take a non-qualified distribution from a Roth IRA, ordering rules determine what portion is taxable. Withdrawals are considered to come from direct contributions first, which are always tax-free. After all contributions are withdrawn, subsequent amounts are considered conversions, followed by investment earnings. Only the earnings portion of a non-qualified distribution is taxed as ordinary income.

Early Withdrawal Penalties and Exceptions

In addition to ordinary income tax, a 10% penalty often applies to early distributions from most retirement accounts. This penalty is assessed on the taxable portion of a withdrawal from a traditional 401(k), traditional IRA, or the earnings portion of a Roth account if you are under age 59½.

This 10% penalty is applied on top of any regular income tax you owe. For instance, if you are under 59½, in the 22% tax bracket, and take a $10,000 early withdrawal from your traditional 401(k), you would owe $2,200 in ordinary income tax plus a $1,000 penalty.

The IRS allows several exceptions to the 10% penalty, although the withdrawal may still be subject to ordinary income tax. Penalty-free withdrawals may be permitted for:

• Total and permanent disability or terminal illness
• Certain unreimbursed medical expenses
• Higher education costs
• A first-time home purchase (up to $10,000 from an IRA)
• Expenses for the birth or adoption of a child (up to $5,000 from a 401(k))
• Certain emergency expenses (up to $1,000)
• Victims of domestic abuse (up to $10,000)
• Those in federally declared disaster areas (up to $22,000)
• Military reservists called to active duty