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You've been contributing to your employer's 401(k) plan and reaping the tax benefits, excluding contributions from your taxable income and allowing your funds to grow tax-deferred in your account. But all good things must come to an end, including tax savings on your 401(k).
When you start making withdrawals from your 401(k) in retirement, you'll start paying taxes on your money—with a few provisos. Here are some basics to know before you set your 401(k) distributions into motion.
How Are 401(k)s Taxed in Retirement?
When you begin withdrawing income from your traditional 401(k) in retirement, your distributions will be taxed as ordinary income. Here's how paying taxes on your 401(k) distributions typically works.
Withholding
With only a few exceptions, your 401(k) distributions are subject to a mandatory 20% withholding. Money withheld from your distributions applies toward your tax bill, similar to paycheck withholding when you're working a job. You'll calculate your final tax bill when you file your tax return and will receive a refund—or pay a remaining balance—at that time.
Estimated Taxes
If your withholding doesn't cover the taxes you'll owe on your retirement distributions, you may have to pay quarterly estimated taxes on the difference.
Reporting
Your plan will report annual distributions to you—and the IRS—using Form 1099-R. Use your 1099-R to report taxable distributions on line 5b of your Form 1040. Distributions figure into your adjusted gross income for the year, along with dividends, capital gains, business income, retirement distributions and additional items like tips, rental property income and—depending on your income—up to 85% of your Social Security benefits (more on this later).
Lump Sums and Rollovers
In some cases, you may be able to withdraw your entire 401(k) balance as a lump sum. If your plan is to roll your funds into a new retirement fund (such as an IRA), follow the rules for rollovers to avoid paying taxes on your distribution.
Required Minimum Distributions
You are required to begin making minimum withdrawals from your 401(k) plan on April 1 of the year following the year you retire, or the year you turn 73 if you continue working. If you don't take the required minimum distributions, the IRS can impose a penalty of up to 25% of the amount you should have taken.
How Much Are 401(k)s Taxed?
Like the income taxes you pay on your regular wages, the tax rate you pay on 401(k) distributions depends on your marginal tax rate and tax bracket. Find your 2023 tax bracket (based on adjusted gross income) and marginal tax rate below.
| 2023 Marginal Tax Rates and Tax Brackets | ||||
|---|---|---|---|---|
| Single | Head of Household | Married Filing Jointly | Married Filing Separately | |
| 10% | $0 - $11,000 | $0 - $15,700 | $0 - $22,000 | $0 - $11,000 |
| 12% | $11,001 - $44,725 | $15,701 - $59,850 | $22,001 - $89,450 | $11,001 - $44,725 |
| 22% | $44,726 - $95,375 | $59,851 - $95,350 | $89,451 - $190,750 | $44,726 - $95,375 |
| 24% | $95,376 - $182,100 | $95,351 - $182,100 | $190,751 - $364,200 | $95,376 - $182,100 |
| 32% | $182,101 - $231,250 | $182,101 - $231,250 | $364,201 - $462,500 | $182,101 - $231,250 |
| 35% | $231,251 - $578,125 | $231,251 - $578,100 | $462,501 - $693,750 | $231,251 - $346,875 |
| 37% | $578,126 or more | $578,101 or more | $693,751 or more | $346,876 or more |
Source: IRS
How Are Roth 401(k) Distributions Taxed?
Distributions from a Roth 401(k) aren't included in your taxable income as long as you meet the requirements for qualified distributions. Because Roth contributions are made with after-tax dollars, you've already paid taxes on your Roth funds.
Qualified Roth 401(k) distributions meet the following requirements:
- Funds have been held in the Roth 401(k) account for at least five years.
- Funds are distributed to you on or after the date you reach 59½, on account of disability, or on or after your death.
How to Minimize Taxes on 401(k) Withdrawals
While it's hard to avoid paying taxes altogether on your 401(k) distributions (unless they're in a Roth), tax planning can help you manage your tax bill in retirement. Here are a few tactics to consider.
Minimize Your Distributions
The more money you withdraw from your 401(k), the more income you'll have—and the larger your tax bill. More income can also mean a higher tax bracket and tax rate, so plan your distributions carefully.
Consider Social Security
Adjusting your distributions may also affect how much tax you'll pay on Social Security benefits. Social Security benefits are sometimes taxed, depending on how much qualifying income you have. For these purposes, calculate your "combined" income by adding your adjusted gross income to any nontaxable interest you've made, plus half of your Social Security benefits. Use the following table to estimate the taxes you'll pay on your Social Security benefits.
| Taxes on Social Security Benefits | ||
|---|---|---|
| Percentage of Benefits Taxed | Combined Income: Individuals | Combined Income: Joint Filers |
| 0% | Up to $25,000 | Up to $32,000 |
| Up to 50% | $25,000 to $34,000 | $32,000 to $44,000 |
| Up to 85% | More than $34,000 | More than $44,000 |
Source: SSA
Treat Company Stock as Capital Gains
Company stock held in your 401(k) may be taxed differently from your other 401(k) assets. The IRS allows the net unrealized appreciation (NUA)—the difference between what you paid for company stock and its current value—to be taxed as capital gains instead of ordinary income when it's distributed from a qualifying employee retirement plan. Long-term capital gains tax rates are lower than marginal tax rates, so this could represent substantial tax savings. Talk with your tax advisor to find out how this rule might work for you.
Live in a Tax-Friendly State
In addition to paying federal income taxes on your 401(k) distributions, you may have to pay state income taxes. If you're concerned about your retirement tax bills, it may be worth looking into state-by-state differences. However, make sure you look beyond income taxes: Property taxes, sales tax and other state and local taxes may compensate for low or no state income taxes.
Get Tax Advice
Your tax situation changes when you stop earning paychecks and start collecting retirement. Your retirement income might include 401(k) distributions, investment income, Social Security, part-time wages and more. Structuring your income to keep your taxes low is a complex proposition. A qualified tax advisor or financial planner can share much-needed expertise.
The Bottom Line
The tax advantages of saving in a 401(k) plan often outweigh the tax burden you shoulder when you retire. You may receive matching dollars that amplify your contributions. You may deduct (or exclude) your contributions from taxable income. You may avoid paying taxes on any capital gains, dividends or interest you earn along the way. And your tax rate may be lower in retirement than it was during your prime earning years, resulting in a lower tax bill overall.
However, your individual circumstances are uniquely yours. Whether retirement is near or far into the future, this may be a good time to check up on your finances. Make sure you're saving enough for retirement and keeping track of your credit report and credit score, so you'll be prepared for taxes—and everything else—that may come your way when you retire.