When thinking about your future, you might be considering saving for retirement and how to fund your golden years after you’ve stopped working. A 401(k) plan is a great way to invest your pre-tax dollars throughout your career to fund your retirement. By contributing to this plan, you’re essentially reducing your taxable income upfront, allowing you to contribute more to your retirement fund for the future.
While the money going into your 401(k) plan is not taxed, it may be taxed (and possibly penalized) when you go to withdraw your funds. You might be asking yourself questions like “How much tax should I withhold from a 401(k) withdrawal?” or “How do I know if I’ll be penalized?” which are common questions when discussing a 401(k) plan.
Keep reading to learn more about the 401(k), its taxes, and its penalties, which are especially important when filing your taxes.
The 411 on 401(k)s
It’s important to understand how money is contributed to a 401(k) before understanding how 401(k) withdrawals are taxed. Generally, 401(k) contributions can be untaxed if they come out of your paycheck, otherwise known as “pre-tax income.” This means two things:
- You will not be paying taxes on these contributions as they enter your 401(k) plan.
- These deductions can reduce your adjusted gross income.
A few additional notes about 401(k) contributions that are essential to know:
- The W-2 that you receive from your employer will show how much you contributed to your 401(k) throughout the year if you contributed pre-tax dollars.
- In 2022, the limit that you can contribute to your 401(k) plan is $20,500 annually if under the age of 50. If 50 or older, that limit increases to $27,000.
- You can choose how much of your paycheck you want to contribute to your 401(k). Some employers match contributions up to a certain percentage. It’s always best to follow up with your HR department and 401(k) provider to get your specific details.
So if these deductions aren’t taxed at the time of entering your 401(k) plan, you might wonder if your 401(k) contributions get taxed at all. The short answer is that they get taxed at the time of withdrawal.
Many 401(k) plans require a 20% mandatory withholding on 401(k) distributions. If you withdraw from your 401(k) before the age of 59.5 (also known as an early distribution), you will have to pay a 10% penalty on the early withdrawal. You may be able to avoid the 20% tax if you roll over your distribution directly from one 401(k) plan to another eligible plan or to an IRA.
The exception to these rules is if you have a Roth IRA plan, where money enters the plan post-tax so that the distributions may be untaxed.
How Much Tax Should I Withhold From a 401(k) Withdrawal?
As with many financial topics, the taxes and penalties on 401(k) distributions can vary depending on the circumstances. Keep reading to understand how 401(k) distributions are affected based on different ages and life events.
Withdrawing money from your 401(k) before the age of 59.5 is considered withdrawing early. This can lead to a few consequences that typically don’t occur if you were to wait until the age of 59.5:
- You may have to pay an early withdrawal penalty to the tune of 10% of your distribution amount at tax time which is known as the 401(k) early withdrawal penalty.
- A longer-term consequence of withdrawing early: You’ll have less money later in life when you’ll need it the most.
While you cannot escape the taxes that the IRS will require, you might be able to avoid the 10% penalty for an early withdrawal under certain circumstances. These can include:
- Qualifying for a hardship distribution
- Giving birth to a child
- Using the funds to pay an IRS levy
- Using the funds to pay for certain medical bills
- Falling victim to a disaster
- Military service
Withdrawing for Retirement
At the age of 59.5, you can officially withdraw your 401(k) without the 10% IRS penalty due to retirement. However, you will still need to pay taxes on any money received unless you directly roll over your distribution to another eligible 401 (K) plan or IRA within 60 days of distribution. 401(k) distributions are taxed as regular taxable income in the year it is withdrawn.
In general, any taxable distribution paid to you is subject to mandatory withholding of 20%, but at tax-time your tax on the distribution will be based on your federal tax rate so you may get some of the taxes back if the 20% originally withheld is more than your actual federal tax rate for your tax bracket.
Additionally, it’s important to note that at the age of 73 in 2023, you must start to take required minimum distributions (RMDs) from your 401(k) account. If you do not, the IRS can assess a penalty of 50% of the amount that should have been taken.
When Can You Withdraw From Your 401(k)?
As stated above, you can either withdraw from your 401(k) before the age of 59.5 (if necessary) or, more ideally, at the age of 59.5 or later. Below, we dive into the two circumstances more in depth. As always, if you have any specific questions regarding withdrawing from your 401(k) plan, it’s best to speak with your 401(k) plan administrator for specific plan details. If you have specific questions regarding tax implications of withdrawing from your 401K, you can connect live via one-way video to a TurboTax Live tax expert with an average of 12 years experience to get your tax questions answered.
You can withdraw from your 401(k) without penalty once you’ve reached the age of 59.5. You may choose to not withdraw at this time if you don’t need the funds yet; in this case, you can wait until the age of 73 to withdraw from your 401(k). Keep in mind that once you’ve hit the age of 73, withdrawing is not optional — it is mandatory.
While it’s not necessary to withdraw the whole amount once you’ve hit the age of 73, there are required minimum distributions in place. If you choose not to take the required minimum distribution amount, the IRS can penalize you 50% of the amount that was not distributed. Remember, however, that you can withdraw more than the minimum required amount.
The money that you withdraw is taxable as regular income in the year that you take it, similar to income from a job. The amount of taxes you will owe on this money is based on the federal tax bracket that you are in at the time of distribution. If you’re still working at the time of withdrawal, the taxable income from your job plus your 401(k) distribution might lift you into the next tax bracket, so it’s important to review this before a distribution request.
There might be times in life before you hit the age of 59.5 when you need immediate funds due to financial hardship. Your 401(k) can help you in times of need when times are tough. These funds are penalty-free but are still taxed. Usually, withdrawals before age 59.5 are subject to a 10% early withdrawal penalty at tax-time, however early withdrawals due to hardships may not be subject to the additional 10% tax penalty.
To receive a 401(k) hardship distribution, it must be both:
- Due to a severe and sudden financial need, and
- Only the amount necessary to cover the financial need
When it comes to hardship distributions, some automatically qualifying events remove the 10% early distribution penalty. The below circumstances are covered for the employee, spouse, children, dependents and beneficiaries of the employee unless otherwise stated:
- Funeral expenses
- Costs related to the repair of the employee’s primary residence
- Costs related to the purchase of the employee’s primary residence (with the exclusion of mortgage payment)
- Medical expenses
- Costs related to preventing the eviction of the employee from the primary residence, or similarly, to prevent the foreclosure on the mortgage of the primary residences
- Tuition and related expenses for the next year of postsecondary education
While these distributions are still taxed, they are not penalized and do not need to be repaid, making them a viable resource if needed. It is important, however, to exhaust all available resources first, as taking this withdrawal will leave you less money for the future.
The Last Resort
If you’re in a financial bind that doesn’t quite meet the qualifications of hardship but still requires immediate financial help, you might be able to still withdraw from your 401(k) early. This is usually looked at as a very last resort for many reasons.
First, you will still be subject to the same automatic 20% tax withholding, and you will also be subject to a 10% penalty on your distributed amount if under the age of 59.5. These can add up quickly, making your overall distribution smaller. While this payout might be helpful now, it will also reduce the amount of income you will have later on in life.
How Can You Reduce Your 401(k) Taxes?
Ultimately, taxes will need to be paid on 401(k) distributions eventually; after all, they were put into the account with pre-tax dollars. However, there are some ways to help reduce the taxes on these funds.
1. Borrow From Your 401(k)
In many, if not most, 401(k) plans, you might be able to request a loan on your 401(k) balance. This lets you acquire the money that you need, tax-free, as long as you pay the loan back on time.
Besides the benefit of this money not being taxed, you end up paying the interest back to yourself instead of a bank. These funds do not need to be claimed on your tax returns.
The amount that you can take a loan on is dependent on a few factors. The IRS allows individuals to request a loan of up to $50,000 or 50% of their vested balance, whichever is less. The exception to this rule: If your vested balance is less than $10,000, you may be able to borrow up to $10,000, provided you have an account value of $10,000 or more.
Here are some examples of how these rules apply:
- If you have an account value of $12,000 but a vested balance of $9,000, you can borrow $10,000. 50% of $9,000 is only $4,500, meeting the exception rule.
- If you have a vested balance of $150,000, the maximum amount you can borrow is $50,000.
- If you have a vested amount of $60,000, the maximum amount you can borrow is $30,000, or 50% of your vested total.
It’s important to remember that each 401(k) plan has its own rules and limits for loans; follow up with your employer or 401(k) administrator for specifics regarding your policy.
2. Consider Your Tax Bracket
Because your 401(k) distributions can bump you up into another tax bracket, it might be wise to only take the amount to reach your upper limit of that tax bracket without breaking into the next one. Keep in mind that the 401(k) income will be added with any other taxable income (such as wages), so keeping your taxable income (after deductions) under the next tax bracket will help in keeping your taxes down.
3. Roll Over Your Old 401(k)
If you’re still working at your current employer, you do not need to withdraw from your current 401(k). However, if you have any 401(k)s with previous employers, you would need to take a required minimum distribution from these accounts if you hit the age of 73. Again, by taking these RMDs, you will be taxed according to your tax bracket.
To avoid these taxes, you can roll your old 401(k)s into your current 401(k) before you turn 73 years old. This will not only keep all of your 401(k) funds together in one account but will also allow you to continue to gain on your total investment amount, without needing to take a required distribution.
4. Get Tax Help
If you still have questions, don’t worry. TurboTax has you covered and will easily guide you through your retirement investments. You can also connect live to a TurboTax Live tax expert with an average of 12 years of experience. With TurboTax Live, you can get year-round expert tax advice and guidance in English and Spanish when you need it the most. TurboTax Live tax experts can guide you along the way or fully do your taxes for you from start to finish at tax time.
The 401(k) retirement plan is a beautiful way to build up a nest egg for the future, but it can also be tricky to understand the ins and outs of all the rules that go along with it. Below are some common questions regarding 401(k)s.
How Is a 401(k) Different From a Roth IRA?
While there are several differences between the traditional 401(k) plan and a Roth IRA, the biggest one is how the taxes are impacted. With a 401(k), the funds are placed into the account with pre-tax dollars, meaning that takes will be paid upon withdrawal. With a Roth IRA, funds are taxed first and then placed into the account, meaning that the withdrawal is tax-free.
What Is the 401(k) Withdrawal Age?
Your 401(k) funds traditionally can be collected starting at the age of 59.5. If you do not need these funds at this time, you can hold off on collecting until you reach the age of 73, when you must take the required minimum distribution amount.
You can also collect on your 401(k) fund prior to the age of 59.5, though a penalty might be incurred.
Is There Always a Penalty to Withdraw?
There are two main scenarios where a penalty for withdrawing from 401(k) comes into play:
- Withdrawing under the age of 59.5: You will be penalized 10% of the distribution amount (unless eligible for a qualified hardship)
- Withdrawing over the age of 73: If you do not take the required minimum distribution amount, you will be penalized 50% of the amount that should have been distributed.
Are There Always Taxes Associated With 401(k) Withdrawals?
Unfortunately, yes, there are taxes associated with 401(k) withdrawals. Regardless of whether you are under 59.5 or over 59.5, there is a mandatory 20% withholding on distributions. If withdrawing before the age of 59.5, you may also pay a 10% early withdrawal penalty at tax time.
When Will I Receive My 401(k) Funds?
Generally, a 401(k) distribution can take anywhere from a few days to two weeks to reach you. Certain circumstances, however, like employer or administrator policies, could cause the waiting period to be longer than two weeks. For information regarding your specific plan, contact your plan administrator or employer’s HR department. When considering how much tax you should withhold from a 401(k) withdrawal, it’s important to consider the circumstances of the withdrawal. If taking an early distribution, you’ll be subject to different taxes than if you wait until the standard age of 59.5. Regardless of when you withdraw your funds, they will be subject to taxes (and possibly a penalty), so it’s important to plan ahead. Using TurboTax to prepare your taxes can help you sort out tax questions and more involved tax situations to make tax planning easy for you.