How Is Your 401(k) Taxed When You Retire?

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How Is Your 401(k) Taxed When You Retire?

When you withdraw assets from your 401(k), or “take distributions,” as the IRS calls it, you begin to enjoy the income and face the tax repercussions. Distributions from most 401(k)s are taxed as regular income for the majority of individuals. However, the tax burden you’ll face varies depending on whether you have a regular or Roth 401(k) account, as well as how and when you take cash from it.

Key Takeaways

  • The tax treatment of 401(k) distributions depends on the type of plan: traditional or Roth.
  • Traditional 401(k) withdrawals are taxed at an individual’s current income tax rate.
  • In general, Roth 401(k) withdrawals are not taxable provided the account was opened at least five years ago and the account owner is age 59½ or older.
  • Employer matching contributions to a Roth 401(k) are taxable.
  • There are ways to reduce the tax impact of 401(k) payouts.

Figuring Out Your Taxes on a Traditional 401(k)

The tax treatment of distributions from a standard, or classic, 401(k) is pretty straightforward. Your contributions to the plan were made using pre-tax money, which means they were deducted “on top” of your gross pay, lowering your taxable earned income and, as a result, the income taxes you paid at the time. Because of that deferral, taxes on the 401(k) funds become payable once distributions commence.

Distributions from such plans are typically taxed as ordinary income at the rate applicable to your tax bracket in the year you make the withdrawal. There are a few exceptions, such as if you were born before 1936 and received your distribution in a lump payment. In this instance, you may be eligible for preferential tax treatment.

The scenario is similar for a traditionalIRA, another tax-deferred retirement account provided by certain smaller organizations (as a SEP IRA) or that a person may create. Traditional IRA contributions are likewise made using pre-tax monies, so taxes are required when the money is withdrawn.

Taxes on a Traditional 401(k)

For example, for the tax year 2021, due on April 18, 2022, a married couple filing jointly and earning $90,000 would pay $9,328 plus 22% of the amount exceeding $81,050. (In tax year 2022, the payment will be $9,615 + 22% of the amount exceeding $83,550.) If the couple’s income increased sufficiently to put them in the next tax bracket, part of the extra money may be taxed at the maximum incremental rate of 24%.

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Because the tax rate is rising, it’s crucial to evaluate how 401(k) withdrawals, which are mandatory after the age of 72, may effect your tax burden after they’re added to other income. “Taxes on 401(k) payouts are critical,” says Curtis Sheldon, CFP®, president of C.L. Sheldon & Company LLC in Alexandria, Virginia. “But, more importantly, what effect will your 401(k) payouts have on your other taxes and fees?”

As an example, Sheldon mentions the taxation of Social Security payments. Normally, Social Security retirement payments are not taxed until the recipient’s total yearly income reaches a particular threshold. A significant 401(k) payout might boost someone’s income beyond the limit, making a large portion of Social Security payments taxable when they would not have been otherwise. If your yearly income exceeds $34,000 ($44,000 for married couples), you may be required to pay taxes on up to 85% of your Social Security payments.

Distributions from conventional 401(k) and traditional IRA funds, like other income, are taxed incrementally, with increasingly higher rates for progressively greater tiers of income. The Tax Cuts and Jobs Act (TCJA) of 2017 decreased rates. However, the fundamental framework of seven tax categories and graded rates remains unchanged. Furthermore, this cut is slated to expire in 2025.

Such an example emphasizes the necessity of being mindful of when and how you take funds from your 401(k) (k).

Taxes on a Roth 401(k)

The tax position is different with a Roth 401(k). As with a Roth IRA, contributions to a Roth 401(k) are made after-tax monies, which means you did not get a tax deduction at the time of the contribution. So, since you’ve already been taxed on your contributions, it’s doubtful that you’ll be taxed on your payouts, if they’re eligible.

To qualify for distributions, the Roth must have “aged” (that is, established) enough from the time you contributed to it, and you must be of legal withdrawal age. “While the designated Roth 401(k) grows tax-free, make sure you fulfill the five-year aging rule and plan distribution regulations to obtain tax-free distribution treatment once you reach the age of 591,” says Charlotte A. Dougherty, CFP®, founder of Dougherty & Associates in Cincinnati, Ohio.

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One key point to remember: these limitations and restrictions apply to the money produced by your account, which is anything other than what you invested into it. Unlike a standard 401(k), you may withdraw your contributions from a Roth 401(k) at any time without penalty. However, the profits must still be recorded on your tax return, as does the total dividend.

Roth 401(k)s, like standard 401(k)s, need required minimum distributions (RMDs) to commence at age 72 (unlike Roth IRAs), however this requirement was abolished for these accounts in 2020 after the passage of the CARES Act.

However, your Roth 401(k) is not totally tax-free. If your company matches your contributions to a Roth, that portion of the money is deemed pre-tax. As a result, when you take distributions, you will have to pay taxes on those contributions. They are subject to regular income taxation.

Special 401(k) Tax Strategies

Other measures relating to retirement funds may assist some people to reduce their tax bite.

Declare Company Stock a Capital Gain

Some corporations provide stock to workers as a form of compensation, and the recipients are generally encouraged to keep such assets in 401(k)s or other retirement plans. While this structure may have drawbacks, it may also have benefits such as more advantageous tax treatment.

According to Christopher Cannon, MS, CFP® of RetireRight Pittsburgh, “Employer stock in a 401(k) plan may be qualified for net unrealized appreciation treatment. This implies that stock increase over the base is recognized as capital gain rates rather than regular income. This may result in significant tax savings. Too many participants and advisers overlook this when dispersing funds or rolling over 401(k)s to IRAs.”

In general, financial advisors believe that paying the long-term capital gains tax is preferable than paying income tax. Income tax rates for persons in higher tax bands are almost double those for capital gains. The capital gains tax rates for 2021 and 2022 are zero, 15%, and 20%, depending on your income level. (In other cases, the percentage might be as high as 25% or 28%.)

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Rollover Funds

You may also avoid paying taxes on your Roth 401(k) earnings if you withdraw for the purpose of rolling them over. There are no extra taxes if the funds are simply transferred to another retirement plan or to a spouse’s plan through direct rollover. To avoid taxes, the money must be put in another Roth 401(k) or Roth IRA account within 60 days if the rollover is not direct, meaning the funds are given to the account holder rather than from one institution to another.

Furthermore, with an indirect rollover, the part of the payout due to contributions cannot be moved to another Roth 401(k), but may be transferred to a Roth IRA. The distribution’s profits may be put into any sort of account.

The Bottom Line

The decision between a Roth 401(k), which is supported by post-tax contributions, and a standard 401(k), which gets pre-tax income, is the first step in managing and lowering the tax burden of your 401(k) account. Some pros recommend keeping both to reduce the danger of having to pay all of the ensuing taxes now or later.

The choices between Roth and normal accounts—if you have access to both—will be influenced by personal criteria such as your age, salary, tax bracket, and domestic status, as with many other retirement decisions. Given the complexities of assessing those factors and others, it is prudent to obtain expert counsel.

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