How Much Do You Get Taxed on 401k?
401k distributions are taxed as income, but your final tax liability depends on more. Learn how timing and location can influence your overall tax bill.
A 401(k) plan allows employees to contribute a portion of their wages to individual accounts. The primary tax implications arise when you withdraw funds during retirement, and the total tax owed depends on several elements.
Federal Income Tax on 401k Withdrawals
When you take money out of a traditional 401(k), the distribution is taxed as ordinary income. This means the withdrawal is not subject to the lower capital gains tax rates that apply to many other types of investments. The amount you withdraw is added to your other sources of income for the year, such as wages or Social Security benefits, to calculate your total taxable income, which determines your marginal tax bracket.
For example, if you are in the 22% federal income tax bracket and withdraw $20,000 from your traditional 401(k), that withdrawal will be taxed at the 22% rate, costing you $4,400 in federal income tax. This amount is reported on your annual tax return using Form 1040.
With a traditional 401(k), contributions are made on a pre-tax basis, which lowers your taxable income during your working years, and withdrawals in retirement are taxed. Conversely, contributions to a Roth 401(k) are made with after-tax dollars, meaning you get no upfront tax deduction. The benefit of a Roth 401(k) is that qualified distributions are entirely tax-free.
For a Roth withdrawal to be considered “qualified,” two conditions must be met. First, the Roth 401(k) account must have been open for at least five years. Second, the account owner must be at least 59½ years old, permanently disabled, or deceased.
The Early Withdrawal Penalty
Taking money out of your 401(k) before reaching age 59½ results in a 10% additional tax on the distribution. This penalty is applied on top of the regular federal and state income taxes you will owe on the withdrawal amount. It is designed to discourage individuals from using their retirement savings for non-retirement purposes.
To illustrate, consider a $10,000 early withdrawal from a traditional 401(k) by someone in the 22% federal tax bracket. This person would owe $2,200 in ordinary income tax on the distribution. In addition, the 10% early withdrawal penalty would amount to another $1,000 ($10,000 x 10%). The total immediate federal tax impact of this early withdrawal would be $3,200, and the penalty is calculated and reported on IRS Form 5329.
The tax code provides several exceptions that allow you to avoid the 10% penalty, including distributions:
- Made due to total and permanent disability.
- Made to a beneficiary after the account owner’s death.
- Used to pay for unreimbursed medical expenses that exceed 7.5% of your adjusted gross income.
- Made as part of a Qualified Domestic Relations Order (QDRO) in a divorce settlement.
- For victims of domestic abuse, up to the lesser of $10,000 or 50% of the vested balance.
- Up to $1,000 per year for unforeseeable personal or family emergency expenses.
- Up to $22,000 for those affected by federally declared disasters.
- Under the “Rule of 55,” which may allow penalty-free withdrawals from that specific employer’s 401(k) if you leave your job in the year you turn 55 or older.
Tax Rules for Rollovers
Moving your 401(k) funds to another retirement account, known as a rollover, preserves the tax-deferred status of your savings if done correctly. The method you choose for this transfer has significant tax implications.
The most common method is a direct rollover, also called a trustee-to-trustee transfer. In this scenario, your old 401(k) plan administrator sends the funds directly to the new account, which could be another 401(k) or an Individual Retirement Account (IRA). Because you never take possession of the money, no taxes are withheld, and the transaction is not a reportable event on your tax return.
An alternative is an indirect rollover, where the plan administrator sends you a check. Your former employer is required by the IRS to withhold 20% of the distribution for federal income taxes. You then have 60 days from the date you receive the funds to deposit the full amount of the original distribution into a new retirement account.
For example, on a $50,000 distribution, you would receive a check for $40,000, with $10,000 sent to the IRS. To complete a tax-free rollover, you must deposit the full $50,000 into a new account within 60 days, using personal funds for the $10,000 difference. The withheld amount can then be recouped when you file your annual tax return.
State Taxes on 401k Distributions
In addition to federal income tax, your 401(k) withdrawals may be subject to state income taxes. The tax treatment of retirement income varies significantly depending on your state of residence during retirement. This geographic factor can have a substantial impact on the net amount of your retirement distributions.
State approaches to taxing 401(k) income fall into three categories. The most common approach is for states to fully tax 401(k) distributions as ordinary income, mirroring the federal treatment. In these states, your withdrawal is added to your other income and taxed at the state’s income tax rates.
A second group of states offers a more favorable tax environment by providing partial exemptions or deductions for retirement income. For instance, a state might allow taxpayers to exclude the first $20,000 of retirement income from their state taxable income. Other states provide specific deductions for individuals over a certain age.
Finally, a small number of states have no state income tax. In these states, your 401(k) distributions will not be subject to any state-level taxation, though federal taxes will still apply.