401(k) withdrawals count as income and must be reported to the Internal Revenue Service (IRS). Beginning at age 59.5, retirees can begin accessing 401(k) funds with no early withdrawal penalty. At age 72, retirees are required to start taking minimum required distributions (RMD).
Key points to remember
- Withdrawals from 401(k) plans are subject to income tax at your effective tax rate.
- During contribution years, retirement savers benefit from lower taxable income.
- Early withdrawals are subject to income tax and possibly a 10% early withdrawal penalty.
All traditional 401(k) withdrawals from the plan are considered income and subject to income tax because 401(k) contributions are made with pre-tax dollars. As a result, retirement savers benefit from lower taxable income in the years they contribute. Correspondence from employers is also treated in the same way.
Once these dollars are invested in the 401(k) plan, they generate earnings as the investments in the account grow in value and pay interest and dividends. These earnings are tax-deferred, meaning your account grows tax-free. This tax freedom ends when you start withdrawing money.
From the age of 59.5 you can withdraw money without penalty, but withdrawals will be subject to the (deferred) tax you never paid when you contributed to the account. As such, your withdrawals will be considered taxable income subject to your effective tax rate.
The idea behind tax-deferred retirement savings is that a person’s tax bracket should be lower at a stage in life when regular employment income has slowed or ceased than when working and contributes. So, instead of paying higher tax rates now, you defer those taxes (along with any growth that has occurred in the account) until you hit that lower tax bracket later.
Contributions to a Roth 401(k) come from after-tax dollars, and so withdrawals from the account are actually tax-free instead of simply tax-deferred.
Note that withdrawals of Roth 401(k)s are treated differently. Contributions are made with after-tax dollars, so withdrawals during retirement are tax-free.
When you take a premature distribution—a withdrawal before age 59½ from a 401(k), Individual Retirement Account (IRA), or other tax-deferred retirement account, or annuity– this withdrawal is also subject to an additional 10% penalty from the Internal Revenue Service (IRS).
There are ways to avoid the early withdrawal penalty. For example, if the amount of your unreimbursed medical expenses exceeds 7.5% of your adjusted gross income and you take a Distribution from your 401(k) to cover these expenses.
401(k) loans are not considered income for income tax purposes. As a result, people who need to operate their accounts often take the money as a loan rather than an actual distribution. Since the loan must be repaid, with interest, it does not trigger the penalty. Most 401(k)s allow you to take out loans up to $50,000 or 50% of the account balance.
If you cannot repay the full loan balance within five years, it is considered a withdrawal and is subject to income tax. If you are under 59.5 at the time, this is also considered an early distribution and also becomes subject to a 10% penalty charge.
Another case in which a 401(k) loan becomes a taxable 401(k) withdrawal is if you cannot repay the remaining loan balance upon termination of your employment with the company where you had the plan.
401(k) rollovers are not taxable, as long as they are transferred to a traditional IRA or a traditional 401(k). Rolling over from a traditional 401(k) to a Roth IRA means the funds will be taxable.
Note that if you do an iindirect rollover, where your plan administrator sends the funds directly to you, you have 60 days to deposit them into a rollover account or face the 10% early withdrawal penalty. A direct bearing is often simpler, where your plan administrator will handle the transfer of money to a new plan or IRA.
Is a 401(K) withdrawal considered earned income or capital gains?
Traditional 401(k) withdrawals are considered income (regardless of your age). However, you will not pay capital gains tax on these funds.
Does a 401(K) withdrawal count as adjusted gross income?
Withdrawals from traditional 401(k)s will increase your adjusted gross income (AGI), as it is considered ordinary income.
Do 401(K) withdrawals count as income for Social Security?
401(k) withdrawals do not count as income in determining your Social Security benefits. However, it could increase your income to the point that you are in a higher tax bracket, meaning your Social Security benefits are taxed at a higher rate.
401(k) withdrawals are considered income and are generally subject to income tax because the contributions and growth were tax-deferred rather than tax-exempt. Yet, by knowing the rules and applying withdrawal strategies, you can access your savings without fear. If you have any questions, consult a tax or financial advisor.