Does 401(k) Really Get Taxed at Retirement? – Avoid This Mistake + FAQs

Traditional 401(k) withdrawals are taxed in retirement. By contrast, Roth 401(k) withdrawals are generally tax-free. But there’s more to the story.

Tax Showdown: Traditional vs Roth 401(k) at Retirement

Your 401(k) can be a tax-deferred treasure or a tax-free fortune at retirement, depending on whether it’s a traditional or Roth 401(k).

The difference is straightforward: one gives you a tax break now and taxes you later, while the other makes you pay now but rewards you with tax-free money later. Below, we delve into each type:

Traditional 401(k) Withdrawals = Taxable Income 😬

If you have a traditional 401(k), be prepared to pay taxes on the money you take out in retirement. Traditional 401(k) contributions are made with pre-tax dollars (they weren’t taxed when you earned them).

As a result, every dollar you withdraw from a traditional 401(k) in retirement is generally taxed as ordinary income. This means your withdrawals will be added to your other income for the year and taxed at your current income tax rate.

For example, imagine you retire and withdraw $50,000 from your traditional 401(k) in a year. If you have no other income, that entire $50,000 counts as taxable income for that year.

It will be taxed according to the federal income tax brackets in effect (after subtracting any deductions you’re eligible for). The more you withdraw in a year, the higher up the tax brackets you go – a very large 401(k) withdrawal could push part of your money into a higher tax rate.

On the bright side, many retirees have lower income in retirement than during their working years. This often means they stay in lower tax brackets. 

It’s important to note that these 401(k) withdrawals are not treated as special “retirement” income by the IRS – they’re taxed just like wages or salary would be.

They are not taxed as capital gains (even though your 401(k) investments grew); instead, they’re taxed as ordinary income. In other words, Uncle Sam treats your traditional 401(k) withdrawal like a paycheck for tax purposes.

Required Minimum Distributions (RMDs): The IRS won’t let you defer taxes on your traditional 401(k) forever. Once you reach a certain age, you’re required to start taking minimum withdrawals each year, known as RMDs.

Currently, new retirees must begin RMDs at age 73 (the required beginning age was recently increased, and it will rise to 75 in coming years).

If you don’t take the required withdrawals, there’s a hefty penalty of 25% of the amount you failed to withdraw. (A recent law change reduced this penalty from 50% to 25%, and it can drop to 10% if you promptly correct the mistake.) The takeaway is that eventually you must take the money out and pay taxes on it.

Early Retirement Caveat: “Retirement” can mean different ages for different people. If you withdraw from your 401(k) before age 59½, those withdrawals usually get hit with a 10% early withdrawal penalty on top of income taxes.

There are some exceptions to this penalty. For instance, if you retire at 55 or older and leave your 401(k) with your former employer, you may be able to take penalty-free withdrawals from that plan – this is often called the “Rule of 55.”

But even if you avoid the 10% penalty, the withdrawn amount is still taxed as regular income. Essentially, with a traditional 401(k), taxes are deferred – not forgiven. You skipped taxes on the money when you contributed, but you’ll settle up with the IRS when you take it out.

Roth 401(k) Withdrawals = Tax-Free Money 🎉

A Roth 401(k) is the flip side of the coin. Contributions to a Roth 401(k) are made with after-tax dollars (you’ve already paid income tax on that money before it goes into the account). Because you’ve paid the tax upfront, qualified withdrawals from a Roth 401(k) in retirement are tax-free.

“Qualified” generally means you’re at least 59½ and the Roth 401(k) account has been open for at least 5 years. Meet those conditions, and every penny you withdraw – contributions and investment earnings – comes out completely free of federal income tax. 🎊

What if you withdraw from a Roth 401(k) and don’t meet the qualified withdrawal rules? In that case, taxes and possibly penalties could apply to the earnings portion of your withdrawal. (Your original contributions can generally come out tax-free since you already paid tax on those, but calculating this in a 401(k) plan can be complex because distributions are typically pro-rated between contributions and earnings.)

The key point: stick to qualified withdrawals with a Roth 401(k) to enjoy the full tax-free benefit.

Another big advantage: Roth 401(k)s (from 2024 onward) no longer have RMDs during the original owner’s lifetime. In the past, Roth 401(k) accounts did require RMDs (unlike Roth IRAs).

However, recent legislation changed this – starting in 2024, Roth 401(k)s are now exempt from RMD rules. That means you can let your Roth 401(k) money grow tax-free for as long as you live, without being forced to withdraw it at a certain age.

If you already started RMDs on a Roth 401(k) under the old rules (or your plan hasn’t adapted yet), you can roll that Roth 401(k) into a Roth IRA to avoid any future RMDs.

No RMDs for Roth IRAs: Roth IRAs have never required minimum distributions during the original owner’s lifetime – you can let a Roth IRA grow untouched all your life.

Roth 401(k)s, as mentioned above, also no longer have RMDs, so now neither type of Roth account forces you to withdraw funds during your lifetime.

Withdrawal Flexibility: Roth IRAs allow you to withdraw your contributions at any time tax-free and penalty-free (even before age 59½).

However, Roth 401(k)s don’t offer that flexibility – if you withdraw from a Roth 401(k) before qualifying age, part of your distribution could be taxable and subject to a 10% penalty (on the earnings portion).

Most people don’t tap a Roth 401(k) early, so this difference is usually not an issue by the time you’re eligible for tax-free withdrawals.

In summary, Roth IRAs and Roth 401(k)s are both superb for generating tax-free retirement income. Many retirees roll their Roth 401(k) into a Roth IRA to consolidate accounts, but from a taxation standpoint, the outcome is the same – no tax on withdrawals. And similar to IRAs and 401(k)s, states generally treat Roth IRA withdrawals the same as Roth 401(k) withdrawals.

State Taxes on 401(k) Distributions: The Location Factor 🗺️

So far, we’ve focused on federal tax rules. But what about state taxes – will your state take a bite out of your 401(k) withdrawals? The answer: it depends on where you live.

State income tax laws vary widely; your retirement income could be fully taxed, partially taxed, or not taxed at all at the state level.

No Income Tax States: If you’re lucky enough to live in a state with no state income tax (such as Florida, Texas, Nevada, Washington, and a few others), you won’t pay any state tax on your 401(k) withdrawals. 

Whether you have a traditional or Roth 401(k), any money you pull out is free from state income tax simply because the state doesn’t tax income, period. This is one reason Florida and similar states are popular retirement destinations – your 401(k) money goes further when the state doesn’t skim off the top.

States That Exempt Retirement Income: Some states have an income tax but specifically don’t tax retirement distributions like 401(k) withdrawals (at least once you reach a certain age).

For example, Illinois, Mississippi, and Pennsylvania generally do not tax withdrawals from 401(k)s, IRAs, or pensions for retirees (Pennsylvania’s exemption applies to distributions after age 59½). This is a huge advantage – effectively, these states treat retirement income as tax-free while still taxing wages for those still working.

States With Partial Exemptions or Credits: Many other states offer partial breaks on retirement income. They might exempt a certain dollar amount each year or provide a tax credit for retirement income.

For instance, New York allows residents over 59½ to exclude up to $20,000 per year of retirement income (whether from an IRA, 401(k), or pension). Georgia has a large exclusion (around $65,000 per person over age 65) for any retirement income. (Various other states have their own exclusions or credits.)

States That Tax Retirement Income Fully: On the other end of the spectrum, some states tax 401(k) withdrawals just like any other income, with no special breaks.

For example, California offers no exclusion for 401(k) or IRA withdrawals – they’re taxed at California’s normal income tax rates, just like other income. 

If you retire in California with a large 401(k), be prepared for the state to claim its share. Essentially, in these places, a $50,000 401(k) withdrawal will be subject to state income tax at your ordinary state tax rate, just as if it were $50,000 of wages.

Where Pensions vs 401(k)s Differ (State Taxes): Some states draw a distinction between pension income and 401(k)/IRA income. For instance, Alabama and Hawaii exempt many pension payments (from defined benefit plans) from state tax but do tax distributions from 401(k)s and IRAs.

This means a company pension could be tax-free in those states, while your 401(k) withdrawals would still be taxed. Keep an eye on these nuances – the type of retirement plan can matter for state taxes.

Plan Where You Live (or Move): The state tax factor means it’s wise to consider where you’ll live in retirement. The difference can be stark: imagine two retirees each withdrawing $60,000 from a traditional 401(k) annually – one lives in Florida (no income tax), the other in California (~9% state tax at that income level).

The Floridian pays $0 in state tax on that withdrawal; the Californian could pay around $5,400 on the same amount. Over a decade, that’s a difference of over $50,000! No wonder some retirees relocate to more tax-friendly states once they stop working. 🌴

401(k) vs IRA vs Pension: Which Retirement Income Gets Taxed More? 🤔

Not all retirement accounts are created equal, but in terms of taxation, many follow similar rules. Let’s compare how 401(k) taxation at retirement stacks up against other common retirement income sources – namely Traditional IRAs, Roth IRAs, and pensions. Understanding the similarities and differences can help you manage multiple income streams efficiently.

401(k) vs Traditional IRA: Same Tax Bite?

A Traditional IRA (Individual Retirement Account) works much like a traditional 401(k) when it comes to taxes at retirement. Both are tax-deferred accounts funded with pre-tax contributions (assuming your IRA contributions were deductible).

Withdrawals from a traditional IRA are taxed as ordinary income, just like 401(k) withdrawals. If you take $10,000 out of your traditional IRA, it’s added to your taxable income for the year – there’s no special tax rate, it’s not capital gains, it’s just like a paycheck or any other income in the eyes of the IRS.

Traditional IRAs also have Required Minimum Distributions (RMDs), and those rules align with 401(k) rules – RMDs start at age 73 for most folks now, forcing you to take out at least a calculated amount each year (and pay taxes on it). The penalty for missing an IRA RMD is the same 25% (reduced to 10% if corrected) as for 401(k)s.

One minor difference: IRA withdrawals give you a bit more flexibility with penalties. Both 401(k)s and IRAs penalize most pre-59½ withdrawals with 10%, but IRAs have a few additional exceptions (like for first-time home purchase up to $10k, higher education expenses, etc.) that 401(k)s might not.

However, these are specific cases. Generally, from a pure tax perspective, a traditional IRA and a traditional 401(k) in retirement are taxed identically.

On the state side, states typically treat IRA withdrawals the same as 401(k) withdrawals. If a state exempts 401(k) distributions, it usually exempts IRA distributions too (and vice versa).

For example, Illinois and Mississippi exempt both, while California taxes both. So you can think of your traditional IRA and 401(k) as cousins in tax treatment. 👍

Roth 401(k) vs Roth IRA: Double Dose of Tax-Free?

What about a Roth IRA versus a Roth 401(k)? The good news is that both offer tax-free withdrawals in retirement under the same conditions (age 59½ + account age 5 years or more).

So if you satisfy the requirements, your Roth IRA withdrawals are just as tax-free as Roth 401(k) withdrawals. In retirement, pulling money from a Roth IRA will not generate any federal income tax, and usually no state tax either (since states typically follow the federal lead on Roth treatment).

There are a couple of nuanced differences between Roth IRAs and Roth 401(k)s:

No RMDs for Roth IRAs: Roth IRAs have never had required minimum distributions for the original owner’s lifetime – you can let a Roth IRA grow untouched all your life. Roth 401(k)s, as mentioned earlier, also no longer have RMDs (as of 2024), so now neither type of Roth account forces you to withdraw funds during your lifetime.

Withdrawal Flexibility: Roth IRAs allow you to withdraw your contributions at any time tax-free and penalty-free (even before age 59½). However, Roth 401(k)s don’t offer that flexibility – if you withdraw from a Roth 401(k) before qualifying age, part of your distribution could be taxable and subject to a 10% penalty (on the earnings portion). Most people won’t tap a Roth 401(k) early, so this difference is usually not an issue once you’re eligible for tax-free withdrawals.

401(k) vs Pension: Taxed the Same, or Not?

A pension (traditional defined benefit plan) provides regular income after you retire. At the federal level, those pension payments are usually fully taxable as ordinary income, just like a 401(k) distribution.

If you receive $30,000 a year from a pension, you must include that in your taxable income, and it will be taxed according to your tax bracket (just like a $30k withdrawal from a 401(k)). There’s typically no special federal tax break for pension income.

(One small exception: if you contributed after-tax dollars to your pension, that portion of your payments would be tax-free as a return of your own contributions.) By and large, assume pension checks are taxed like paychecks by the IRS.

Where pensions can differ is at the state level – some states are more generous in how they tax pensions compared to 401(k) distributions. A number of states fully exempt public pensions (and sometimes even private pensions) from state income tax. Others give a deduction or credit for pension income that they don’t offer for 401(k)/IRA withdrawals.

Historically, states often wanted to favor their retired public employees or saw pensions as different from other retirement income. However, after the Davis v. Michigan case (1989), states cannot tax federal pensions while exempting state pensions – they must tax similar pensions equally.

But a state can choose to exempt all pension income while still taxing 401(k)/IRA distributions. Many states have moved toward parity, treating 401(k) and pension income similarly, to avoid picking winners and losers.

One more difference: a pension typically just shows up as a fixed payment, whereas a 401(k) requires you to decide how much to withdraw and when. This gives 401(k) holders some tax-planning leverage – you can withdraw less in a high-income year or more in a low-income year to manage your tax bracket.

On the flip side, managing your own 401(k) withdrawals adds responsibility. You don’t want to withdraw so slowly that you never get to enjoy your money (and remember, RMD rules will eventually force you to start taking it out).

With pensions, you often have a choice at retirement between a lifetime annuity (monthly payments) or a lump sum. If you take a lump sum, rolling it over to an IRA or 401(k) lets you keep it tax-deferred, whereas cashing it out would make the entire amount taxable at once. Most people avoid that big tax hit by choosing the annuity or a direct rollover.

In summary: From a federal tax perspective, 401(k)s, IRAs, and pensions are very similar – traditional versions are taxed as ordinary income, and Roth or post-tax versions are tax-free. The differences are mostly about the rules (contribution limits, withdrawal flexibility, RMDs) and about state tax treatment, rather than the taxation itself.

It’s important to look at your entire retirement income picture to optimize taxes across all sources. For example, if you have a pension and a large traditional 401(k), you might end up in a higher tax bracket than expected because the pension is already filling up your lower tax brackets.

In that case, doing some Roth conversions with your 401(k)/IRA money before the pension starts or before RMDs kick in could save you money on taxes in the long run. On that note, let’s look at some smart strategies to manage and minimize taxes on your 401(k) withdrawals.

Smart Strategies to Reduce 401(k) Taxes in Retirement 💡

You’ve worked hard to build your 401(k), and you want to keep as much of it as possible. While taxes on a traditional 401(k) are inevitable, there are strategies to minimize the tax hit or at least avoid unpleasant surprises. Here are some savvy moves and considerations for managing 401(k) taxes in retirement:

• Plan Your Withdrawals with Tax Brackets in Mind: Remember that 401(k) withdrawals are taxed as ordinary income in the year you take them. However, you have control over when and how much to withdraw – so use that to your advantage. For instance, if you need a large sum from your 401(k), consider spreading it over several years instead of taking it all at once. This keeps your taxable income lower each year and helps you avoid jumping into a higher tax bracket. In short, try to fill up the lower tax brackets but not leap into much higher ones if possible. 📊

• Leverage the Standard Deduction: The standard deduction can shield a chunk of your retirement income from tax each year. For example, if a married couple has a standard deduction of about $30,000, they could withdraw $30k from a traditional 401(k) and pay zero federal tax on that portion (the deduction offsets it). If they need $50k total, only $20k would be taxable. At a minimum, consider withdrawing up to your deduction amount each year from tax-deferred accounts, since that portion can come out tax-free.

• Roth Conversions in Low-Income Years: If you have some years in retirement where your income is low (for example, before Social Security or a pension starts), consider converting part of your traditional 401(k)/IRA to a Roth IRA. You’ll pay tax on the converted amount now at a lower rate, and future withdrawals from the Roth will be tax-free. Doing these conversions gradually can reduce your future RMDs and potentially save on total taxes.

• Coordinate with Social Security: 401(k) withdrawals can also affect how much of your Social Security gets taxed (up to 85% of your benefits can become taxable if your income is high). Plan these income streams together. For example, you might delay Social Security and use more 401(k) income in early retirement (or vice versa) to manage your tax bracket. The key is to be mindful of the interplay between withdrawals and Social Security taxation.

• Watch Medicare Premium Brackets (IRMAA): Large 401(k) withdrawals can also increase your Medicare Part B and Part D premiums. There are income thresholds (IRMAA brackets) where even $1 over the limit will raise your monthly Medicare costs. Try to avoid unplanned withdrawals that push you over those thresholds. (Roth 401(k) withdrawals don’t count toward these income limits.)

• Use QCDs for Charity: If you’re 70½ or older and donate to charity, consider a Qualified Charitable Distribution (QCD) from your IRA (you can roll 401(k) funds into an IRA to use this). A QCD allows you to donate up to $100,000 directly from your IRA to charity each year, and that withdrawal is not taxed. It also counts toward your RMD, reducing your taxable required distributions. This way, you support a cause and save on taxes at the same time.

• Avoid Tax Surprises (Withholding): For any taxable 401(k) withdrawals, make sure you cover the taxes via withholding or estimated payments. Unlike a paycheck, taxes aren’t automatically withheld from retirement distributions unless you request it. If you take large withdrawals without withholding, you could face a big tax bill and possible penalties at tax time. Plan to pay the IRS throughout the year (instead of all at once later) to avoid surprises.

• Where You Live Matters: Relocating to a state with low or no income tax can significantly reduce taxes on your 401(k) withdrawals. If you’re flexible, compare different states’ tax rules on retirement income. Even establishing residency in a more tax-friendly state (while spending time elsewhere) can yield big tax savings – just be sure to follow that state’s residency rules. Of course, consider other factors like cost of living and family, but from a pure tax perspective, location can make a huge difference.

Frequently Asked Questions (FAQs)

Q: Do I have to pay taxes on my 401(k) when I retire?
A: Yes. If you have a traditional 401(k), withdrawals in retirement are subject to income tax. (If you have a Roth 401(k), qualified withdrawals are tax-free.)

Q: Are 401(k) withdrawals taxed as ordinary income?
A: Yes. Traditional 401(k) withdrawals are taxed as ordinary income, just like a paycheck. They don’t get any special lower tax rate.

Q: Is a Roth 401(k) really tax-free at retirement?
A: Yes. As long as you’re over 59½ and the Roth 401(k) was opened at least 5 years ago, your withdrawals (contributions and earnings) are completely tax-free.

Q: Do I pay state taxes on 401(k) withdrawals?
A: It depends. In many states you do pay state income tax on 401(k) withdrawals, but some states have no income tax or specifically exempt certain retirement income.

Q: Will my 401(k) withdrawals bump me into a higher tax bracket?
A: Possibly. 401(k) withdrawals add to your taxable income for the year, which could push you into a higher tax bracket if the amounts are large enough.

Q: Do I have to withdraw all my 401(k) money when I retire?
A: No. You are not required to immediately cash out a 401(k) at retirement. You can leave it invested until at least age 73, when RMD rules force some withdrawals.

Q: Are 401(k) withdrawals considered “earned income”?
A: No. They count as taxable income, but not as earned income for things like Social Security earnings tests or IRA contribution eligibility. They are treated as retirement distributions.

Q: Can I avoid paying taxes on my traditional 401(k) altogether?
A: No. Eventually you must pay tax on a traditional 401(k). However, you could convert it to a Roth (paying tax on the conversion) or use strategies like QCDs to reduce the taxable amount.

Q: Are 401(k) distributions taxed twice (when contributed and when withdrawn)?
A: No. Traditional 401(k) money is only taxed once – when you withdraw it (it wasn’t taxed when you contributed). Roth 401(k) money is also taxed just once – when you contribute, not when withdrawn.

Q: Which is better for taxes, a traditional or Roth 401(k)?
A: It depends. A traditional 401(k) gives you a tax break upfront but is taxed on withdrawals; a Roth 401(k) has no upfront break but withdrawals are tax-free. Which is better depends on your individual situation.