Do You Pay Tax on a 401(k) Withdrawal?

A 401(k) plan is a popular employer-sponsored retirement savings vehicle. Understanding its tax implications is important, as treatment varies by account type and the timing of contributions, growth, and withdrawals. This overview clarifies the tax landscape of 401(k) plans from initial funding to eventual distribution.

Tax Implications of Contributions

Contributions to a 401(k) plan are generally made through payroll deductions, and their tax treatment depends on whether the plan is a Traditional or Roth 401(k). Traditional 401(k) contributions are made on a pre-tax basis, meaning they reduce an employee’s current taxable income. This allows for a deferral of income tax on those contributed amounts until they are withdrawn during retirement.

Conversely, contributions to a Roth 401(k) are made with after-tax dollars, which means they do not provide an immediate tax deduction. The primary benefit of a Roth 401(k) arises in retirement, where qualified withdrawals, including both contributions and earnings, can be entirely tax-free. This structure is advantageous for individuals who anticipate being in a higher tax bracket in retirement.

Employer contributions, such as matching contributions or profit-sharing, are made on a pre-tax basis and are not immediately taxable to the employee. These contributions are subject to taxation when withdrawn during retirement. While employer contributions do not count against an employee’s individual contribution limit, they are included in a separate overall limit for combined employee and employer contributions.

Annual limits apply to 401(k) contributions. For 2025, the employee salary deferral limit for Traditional and Roth 401(k)s is $23,500. Individuals aged 50 and older can make catch-up contributions, with a limit of $7,500 for 2025. Under the SECURE 2.0 Act, those aged 60 to 63 can contribute a higher catch-up amount of $11,250 in 2025, if their plan allows. The total combined contributions from employee and employer cannot exceed $70,000 in 2025 for those under 50, with higher limits for those making catch-up contributions.

Tax Treatment of Investment Growth

Investment earnings within a Traditional 401(k) benefit from tax-deferred growth. Taxes on these earnings, along with original pre-tax contributions, are deferred until the funds are distributed from the account in retirement. This allows investments to compound and grow over time without yearly tax obligations.

Investment earnings within a Roth 401(k) also grow tax-free. The key distinction for Roth accounts is that if withdrawals are “qualified,” these earnings are entirely tax-free upon distribution in retirement. This dual benefit of tax-free growth and tax-free withdrawals makes the Roth 401(k) appealing for long-term savings.

Both Traditional and Roth 401(k)s offer an advantage over taxable investment accounts, where investment gains and income are subject to annual taxation. The tax-deferred or tax-free growth within a 401(k) allows for efficient wealth accumulation, as the full amount of earnings can be reinvested without immediate tax erosion. This compounding effect enhances the potential for retirement savings.

Taxation of Distributions

The taxation of 401(k) distributions depends on the account type, the account holder’s age, and withdrawal circumstances. For Traditional 401(k) plans, all withdrawals in retirement are taxed as ordinary income. This includes original pre-tax contributions and accumulated investment earnings. The tax rate depends on the individual’s taxable income and tax bracket at withdrawal.

For Roth 401(k)s, “qualified withdrawals” are tax-free. A withdrawal is qualified if the account holder is at least age 59½ and the Roth 401(k) account has been established for at least five years. If a Roth 401(k) withdrawal is “non-qualified,” the earnings portion becomes taxable as ordinary income and may be subject to a 10% penalty. Original contributions to a Roth 401(k) can be withdrawn tax-free at any time.

Withdrawals made from a 401(k) before age 59½ are generally subject to both ordinary income tax and an additional 10% early withdrawal penalty. This penalty applies to the taxable portion of the distribution, which for a Traditional 401(k) is the entire amount withdrawn, and for a Roth 401(k) is the earnings portion of a non-qualified withdrawal. Several exceptions exist that may allow for penalty-free early withdrawals, although the distribution may still be subject to ordinary income tax. These exceptions include:

Distributions due to total and permanent disability.
A series of substantially equal periodic payments (SEPP).
Unreimbursed medical expenses exceeding 7.5% of adjusted gross income.
Qualified higher education expenses.
A first-time home purchase (up to $10,000).
Qualified birth or adoption expenses (up to $5,000 per child).
Certain distributions from an inherited 401(k).
Certain financial emergencies, such as up to $1,000 per year for personal or family emergency expenses (SECURE 2.0 Act).
Distributions for victims of domestic abuse (SECURE 2.0 Act).

Required Minimum Distributions (RMDs) are annual withdrawals Traditional 401(k) account holders must begin taking once they reach a certain age. The SECURE 2.0 Act updated the RMD age, increasing it to 73 for individuals who reached age 72 after December 31, 2022. This age will further increase to 75 for those who turn 74 after December 31, 2032. These distributions are taxed as ordinary income and ensure tax-deferred retirement savings are eventually distributed and taxed.

Roth 401(k)s are exempt from RMDs for the original account owner, a change effective in 2024 due to the SECURE 2.0 Act, aligning them with Roth IRAs. Failure to take a required minimum distribution from a Traditional 401(k) by the deadline can result in an excise tax. The penalty is 25% of the amount not distributed, though it can be reduced to 10% if the shortfall is corrected within a two-year period.