How Taxes on Retirement Withdrawals Work

Accessing funds from retirement accounts involves a distinct set of tax rules. The tax implications of a withdrawal depend on the type of retirement account, your age, and how long the account has been open. Understanding these variables is important for managing your income and tax obligations during your retirement years, as these decisions can substantially impact your net income.

Tax Treatment of Common Retirement Accounts

The way your retirement withdrawals are taxed depends on whether you paid taxes on the money when you put it in or will pay them when you take it out. This distinction in account type dictates the financial outcome of every dollar you withdraw.

Traditional (Pre-Tax) Accounts

Accounts like Traditional IRAs, 401(k)s, and 403(b)s are funded with pre-tax dollars, providing an upfront tax deduction that reduces your taxable income during your working years. The investments within the account grow tax-deferred, so you don’t pay taxes on earnings annually.

When you withdraw money from these accounts in retirement, the distributions are taxed as ordinary income. The amount is added to your other income for the year to determine your total taxable income. For example, a $20,000 withdrawal is added to your income and taxed at your marginal rate, not at a lower capital gains rate.

Roth (Post-Tax) Accounts

Roth IRAs and Roth 401(k)s are funded with after-tax dollars, so you receive no tax deduction when you contribute. In retirement, qualified distributions are entirely tax-free at the federal level, including both your contributions and all investment earnings.

For a withdrawal to be a qualified distribution, two conditions must be met. The first is you must be at least 59½ years old. The second is you must have satisfied the five-year rule, meaning at least five years have passed since your first contribution to any Roth IRA. If you take a non-qualified distribution, your contributions are still tax-free, but the earnings portion will be taxed as ordinary income and may be subject to a penalty.

Nondeductible IRA Contributions

Some individuals make nondeductible, or after-tax, contributions to a Traditional IRA, often due to income limitations. When you withdraw from any of your Traditional IRAs, you must use the pro-rata rule to calculate the taxable portion of the distribution.

This rule determines the ratio of your after-tax contributions to the total value of all your Traditional, SEP, and SIMPLE IRAs. This ratio dictates what percentage of your withdrawal is a tax-free return of contributions and what percentage is taxable. The calculation is reported to the IRS on Form 8606.

Pensions and Annuities

The tax treatment of pension and annuity payments depends on how they were funded. If your employer made all contributions and you used no after-tax money, your full payments are taxable as ordinary income.

If you made contributions with after-tax dollars, a portion of each payment is a tax-free return of your contributions. The remaining portion, representing employer contributions and earnings, is taxable. The payer is responsible for calculating the taxable amount and reporting it to you.

Penalties for Early Withdrawals

In addition to ordinary income tax, a penalty can apply if you access retirement funds too early. The IRS imposes this additional tax to discourage the premature use of retirement savings.

Withdrawals from most retirement plans before you reach age 59½ are subject to a 10% additional tax. For example, a $10,000 early withdrawal from a Traditional IRA would incur a $1,000 penalty on top of any ordinary income tax due. This penalty is reported on Form 5329. A higher 25% penalty may apply to early withdrawals from a SIMPLE IRA if taken within the first two years of participation.

The tax code provides several exceptions that allow you to avoid the 10% penalty, although the withdrawal is still subject to ordinary income tax if from a pre-tax account. Common exceptions include distributions for:

• Death or total and permanent disability.
• Unreimbursed medical expenses that exceed 7.5% of your adjusted gross income.
• Health insurance premiums while unemployed for at least 12 consecutive weeks.
• Qualified higher education expenses for yourself, spouse, children, or grandchildren.
• A first-time home purchase, up to a $10,000 lifetime limit from an IRA.

Required Minimum Distributions

The government does not allow funds in tax-deferred accounts to remain sheltered from taxes indefinitely. To ensure tax revenue is eventually collected, the law mandates that you begin taking withdrawals at a certain age. These are known as Required Minimum Distributions (RMDs).

RMDs are the minimum amounts you must withdraw from your retirement accounts each year. The age to begin taking RMDs depends on your birth year. Individuals born between 1951 and 1959 must start at age 73, while those born in 1960 or later must begin at age 75. Your first RMD is due by April 1 of the year after you reach the applicable age, with subsequent RMDs due by December 31 each year.

These rules apply to tax-deferred accounts like Traditional IRAs, SEP IRAs, SIMPLE IRAs, and 401(k)s. Roth IRAs and Roth 401(k)s are not subject to RMDs for the original account owner, allowing the funds to grow tax-free for your entire life.

Failing to take your full RMD by the deadline results in a penalty of 25% of the amount that was not withdrawn. For example, if your RMD was $20,000 and you only withdrew $5,000, the penalty would be 25% of the $15,000 shortfall. The IRS may reduce this penalty to 10% if you correct the mistake in a timely manner.

State Income Taxes on Retirement Withdrawals

Your retirement withdrawals may also be subject to state income taxes, which vary dramatically by state. State tax laws on retirement income generally fall into several categories.

Some states have no personal income tax, making all retirement income state-tax-free. Other states have an income tax but fully exempt most or all retirement income. Many states offer partial exemptions or tax credits for retirement income, which may be limited by income level or type of retirement account. Finally, some states tax all retirement distributions as regular income.

Because these rules differ widely and can change, you should consult your state’s department of revenue for current information.

Managing Your Tax Liability on Withdrawals

You can pay federal income tax on retirement distributions through either direct withholding or estimated tax payments. Paying enough tax throughout the year helps you avoid an underpayment penalty when you file your annual return.

You can instruct the plan administrator to withhold federal income tax from your distribution. For periodic payments like a pension, you use Form W-4P. For nonperiodic payments like a lump-sum withdrawal, you use Form W-4R. While withholding is voluntary for IRA withdrawals, payers must withhold a mandatory 20% from an eligible rollover distribution from a 401(k).

If you choose not to have taxes withheld or the withholding is insufficient, you may need to make quarterly estimated tax payments using Form 1040-ES. These payments are typically due in April, June, September, and January. You can mail payments with a voucher from the form or pay electronically through IRS Direct Pay.