Does 401k Withdrawal Count as Earned Income?

A 401k is a retirement savings plan, allowing individuals to save and invest for their future on a tax-advantaged basis. When you withdraw money from a 401k, it is not considered “earned income” for tax purposes. This distinction carries significant implications for how these distributions are taxed and how they might affect eligibility for various tax benefits. This article will clarify what constitutes earned income, explain the tax treatment of 401k withdrawals, and detail their impact on common tax credits and deductions.

Understanding Earned Income

Earned income refers to money received from active participation in a trade or business, or from working for an employer. The IRS defines it as taxable income and wages from employment, self-employment, or a business you own. Common examples include salaries, wages, tips, commissions, and net earnings from self-employment, such as income from freelancing or a small business. Union strike benefits and certain disability benefits received before minimum retirement age also qualify.

Many types of income are excluded from the definition of earned income. These include passive income sources like interest and dividends from investments, rental income, and capital gains. Other unearned income examples include Social Security benefits, unemployment benefits, alimony, and child support. Distributions from retirement plans, such as 401k withdrawals, are also classified as unearned income because they represent a distribution of previously earned money and investment growth, not new income from current labor.

Taxation of 401k Withdrawals

While 401k withdrawals are not considered earned income, they are subject to taxation. Distributions from a traditional 401k, funded with pre-tax contributions, are taxed as ordinary income in the year they are received. This means they are added to your other taxable income and are subject to your regular income tax rates.

Roth 401k accounts are funded with after-tax contributions. Qualified distributions from a Roth 401k are tax-free and penalty-free. To be considered qualified, the distribution must occur after a five-year holding period and meet one of several conditions, such as reaching age 59½, becoming disabled, or being made to a beneficiary after your death.

Withdrawals taken from a 401k before age 59½ are subject to a 10% early withdrawal penalty, in addition to being taxed as ordinary income. However, several exceptions allow you to avoid this penalty:

• Distributions made due to total and permanent disability.
• Unreimbursed medical expenses exceeding 7.5% of your adjusted gross income.
• Separation from service at age 55 or older from the plan at the job you are leaving.
• Qualified higher education expenses.
• A first-time home purchase.
• A series of substantially equal periodic payments (SEPP).
• Certain emergency personal expenses, introduced by the SECURE 2.0 Act.
• Distributions for victims of domestic abuse, also introduced by the SECURE 2.0 Act.

Required Minimum Distributions (RMDs) are mandatory withdrawals that begin when you reach a certain age, ensuring tax-deferred retirement savings are eventually distributed and taxed. The SECURE 2.0 Act increased the RMD age. Failure to take a timely RMD can result in a significant penalty. All 401k distributions are reported to the IRS on Form 1099-R by the plan administrator or financial institution.

Implications for Tax Benefits

Since 401k withdrawals are not considered earned income, they do not help an individual qualify for tax benefits that require earned income, such as the Earned Income Tax Credit (EITC). The EITC is a refundable tax credit for low- to moderate-income working individuals and families. While 401k withdrawals do not count toward the earned income threshold needed to qualify for EITC, they do increase your Adjusted Gross Income (AGI), which can reduce or eliminate the credit if your income exceeds certain phase-out thresholds.

The Child Tax Credit (CTC) is another benefit that can be impacted. Although 401k withdrawals do not count as earned income for CTC eligibility, they increase your Modified Adjusted Gross Income (MAGI). The CTC begins to phase out at certain MAGI thresholds, meaning a large 401k withdrawal could push your income above these limits, reducing the amount of CTC you can claim.

Contributions to a Roth IRA are also directly tied to earned income. You cannot contribute more to a Roth IRA than your earned income for the year. As 401k withdrawals are not earned income, receiving these distributions does not create eligibility to contribute to a Roth IRA, regardless of the amount withdrawn. Eligibility for Roth IRA contributions is also subject to MAGI limits.

401k withdrawals can affect eligibility for the Premium Tax Credit (PTC) under the Affordable Care Act (ACA). Eligibility for and the amount of the PTC are determined by your household’s Modified Adjusted Gross Income (MAGI). Since 401k distributions, especially from traditional accounts, are included in your MAGI, a withdrawal can increase your MAGI and potentially reduce or eliminate your PTC, making your health insurance premiums more expensive.

Finally, 401k withdrawals can play a role in the taxation of Social Security benefits. While Social Security benefits themselves are not considered earned income, the amount of these benefits subject to federal income tax depends on your “combined income” or “provisional income.” This calculation includes your AGI, any non-taxable interest, and half of your Social Security benefits. Traditional 401k withdrawals increase your AGI, thereby increasing your combined income and potentially causing a larger portion of your Social Security benefits to become taxable.