Is 401(k) Taxed as Income or Capital Gains?
Understand how 401(k) withdrawals are taxed, including differences between traditional and Roth accounts, potential penalties, and tax treatment of gains.
A 401(k) is a popular retirement savings account with tax advantages, but understanding how withdrawals are taxed can be complex. The tax treatment depends on the type of 401(k), when funds are withdrawn, and whether the withdrawal meets IRS qualifications.
Traditional 401(k) Withdrawal Taxation
Withdrawals from a traditional 401(k) are taxed as ordinary income in the year they are taken. Since contributions are made with pre-tax dollars, the IRS taxes distributions at your marginal income tax rate.
For example, if you withdraw $30,000 in a year where your total taxable income places you in the 22% federal tax bracket, you would owe $6,600 in federal income tax. State taxes may also apply, depending on where you live. Some states, like Florida and Texas, do not tax retirement income, while others, such as California and New York, do.
Required Minimum Distributions (RMDs) must begin at age 73. These mandatory withdrawals are based on life expectancy and account balance. Failing to take an RMD results in a penalty of 25% of the amount that should have been withdrawn, though this can be reduced to 10% if corrected in time.
Roth 401(k) Distribution Taxation
Withdrawals from a Roth 401(k) follow different rules. Contributions are made with after-tax dollars, so the portion of the withdrawal that represents contributions is not taxed. However, earnings are tax-free only if the withdrawal meets IRS qualifications.
To be qualified, the account must have been open for at least five years, starting January 1 of the year of your first contribution, and you must be at least 59½, disabled, or using the funds for a first-time home purchase (up to a $10,000 lifetime limit). If these conditions are met, both contributions and investment gains can be withdrawn tax-free.
If a withdrawal does not meet these conditions, the earnings portion is subject to ordinary income tax and may incur a 10% early withdrawal penalty unless an exception applies. Exceptions include unreimbursed medical expenses exceeding 7.5% of adjusted gross income (AGI) and certain higher education costs.
Capital Gains Treatment Within a 401(k)
Investment growth within a 401(k) is not subject to capital gains tax. Unlike a taxable brokerage account, where selling an investment for a profit triggers capital gains tax, transactions inside a 401(k) do not create immediate tax consequences.
Regardless of how long an asset is held, any appreciation in a traditional 401(k) is taxed as ordinary income upon withdrawal. In a Roth 401(k), qualified withdrawals remain tax-free. This structure eliminates the advantage of long-term capital gains rates that taxable account investors might seek.
Since gains are not taxed annually, 401(k) investors can use strategies like active fund management or frequent rebalancing without tax consequences. However, traditional 401(k) withdrawals are taxed as ordinary income rather than at lower capital gains rates.
Age Requirements and Early Penalties
The standard age for penalty-free withdrawals is 59½, but some exceptions allow earlier access without the 10% penalty.
The Rule of 55 permits penalty-free withdrawals if you leave your job in or after the year you turn 55. This applies only to the 401(k) of your most recent employer and does not extend to IRAs. Another option is Substantially Equal Periodic Payments (SEPP), which allows penalty-free withdrawals if taken as a series of predetermined payments for at least five years or until age 59½, whichever is longer.
Non-Qualified Withdrawals and Their Tax Status
Non-qualified withdrawals occur when funds are accessed outside IRS guidelines, leading to additional taxes and penalties.
Traditional 401(k) non-qualified withdrawals are taxed as ordinary income and subject to a 10% early withdrawal penalty unless an exception applies. Hardship withdrawals, such as those for medical expenses exceeding 7.5% of AGI or a permanent disability, may avoid the penalty but are still taxed as income.
Roth 401(k) non-qualified withdrawals are treated differently. Contributions, made with after-tax dollars, can be withdrawn tax-free at any time. However, earnings on those contributions are subject to income tax and the 10% penalty if the withdrawal does not meet IRS qualifications.