How to Pay Taxes on a 401(k) Withdrawal

Taking a distribution from a 401(k) plan is a taxable event. The amount of money you ultimately receive can be substantially lower than the amount you withdraw once federal and state obligations are met. Planning for a 401(k) withdrawal involves anticipating the taxes and potential penalties that may apply.

Determining Your Tax and Penalty Liability

When you withdraw funds from a traditional 401(k), the money is treated as ordinary income for the year of the distribution. This means the withdrawal amount is added to your other earnings and taxed according to federal income tax brackets. For instance, if you earn $70,000 and take a $30,000 distribution, your total taxable income becomes $100,000 before deductions, which can push you into a higher tax bracket.

Most states also have an income tax and will view the 401(k) distribution as taxable income. The specific state tax rate will vary depending on where you reside, adding another layer to the overall tax liability.

A distribution taken before you reach age 59½ is subject to an additional 10% tax on top of ordinary income taxes. This early withdrawal penalty is established under Internal Revenue Code Section 72.

The IRS allows for specific exceptions that can help you avoid the 10% additional tax, though each has specific criteria. A distribution may be exempt if it is:

• Made to a beneficiary after the account owner’s death.
• Made because the owner becomes totally and permanently disabled.
• Used for certain medical expenses exceeding 7.5% of your adjusted gross income (AGI).
• Made to an alternate payee under a Qualified Domestic Relations Order (QDRO).
• Taken as a series of substantially equal periodic payments.
• Taken after separating from service if you are age 55 or older.
• Made to qualified military reservists called to active duty.
• Made to individuals certified by a physician as being terminally ill.
• Up to $22,000 for expenses in a federally declared disaster area.
• One distribution of up to $1,000 per year for emergency personal expenses.
• Made to victims of domestic abuse, for the lesser of $10,000 or 50% of the account value.

Navigating Mandatory Tax Withholding

When you request a distribution from your 401(k) plan, your plan administrator is required to withhold a portion of it for federal income taxes. For most withdrawals paid directly to you, the mandatory withholding rate is a flat 20%. This automatic withholding is a prepayment toward your total tax liability for the year.

This 20% withholding is not the final amount of tax you will owe, as your actual tax rate is determined by your total annual income. If your marginal tax rate is higher than 20%, you will be responsible for paying the remaining balance when you file your tax return. Conversely, if your tax rate is lower, the excess amount withheld will be applied against other taxes you owe or refunded to you.

Reporting the Withdrawal on Your Tax Return

After the year of your distribution, your plan administrator will send you Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans. This form is mailed by January 31 and contains the information needed to report the withdrawal on your tax return.

Several boxes on Form 1099-R provide details about your distribution. Box 1 shows the total amount of the distribution, while Box 2a reports the taxable portion. Box 4 details the amount of federal income tax that was withheld.

Box 7 of Form 1099-R contains a distribution code that tells the IRS about the nature of your withdrawal. For example, a code ‘1’ indicates an early distribution where no known exception to the 10% penalty applies. A code ‘2’ signifies an early distribution where an exception may apply.

When you file your annual tax return, you will use the information from Form 1099-R to report the income on Form 1040. The federal income tax withheld, shown in Box 4, is added to your other tax payments for the year.

If you are subject to the 10% additional tax or qualify for an exception, you must file Form 5329, Additional Taxes on Qualified Plans. This form is used to calculate the penalty you owe or to claim an exception. The total penalty calculated on Form 5329 is then transferred to your Form 1040.

Strategies for Managing the Tax Payment

If the mandatory 20% federal withholding is not sufficient to cover your total tax liability, you may need to make estimated tax payments to the IRS. This is particularly relevant if the distribution pushes you into a higher tax bracket or if you are subject to the 10% early withdrawal penalty. Failing to pay enough tax throughout the year can result in an underpayment penalty.

You can make these payments quarterly using Form 1040-ES, Estimated Tax for Individuals. Calculating the correct amount can prevent a surprise tax bill and penalties when you file your annual return.

The tax rules discussed apply to traditional 401(k) plans, where contributions are made on a pre-tax basis. In contrast, a Roth 401(k) is funded with after-tax contributions, which means that qualified distributions are entirely tax-free.

A qualified Roth distribution is one made after you have held the account for at least five years and have reached age 59½, become disabled, or died. If you meet these criteria, the withdrawal is not subject to federal or state income tax, or the 10% early withdrawal penalty. For individuals with both traditional and Roth 401(k) options, choosing to withdraw from the Roth account can eliminate the tax burden.