Yes, most 401(k) withdrawals are taxed as ordinary income

When you withdraw money from a traditional 401(k), the IRS treats it as income for that year. You will owe federal income tax on the full amount you withdraw — not just the earnings, but also the money you contributed from your paychecks. The tax is calculated at your regular income tax rate, which depends on your total income that year and your tax bracket.

The reason is straightforward: your original contributions went into the 401(k) before taxes were taken out. Your employer did not withhold federal income tax on that money when you earned it. The account was designed to let that money grow tax-deferred until you took it out. When you do withdraw it, the IRS collects the tax it deferred.

Your employer's plan administrator will usually withhold a percentage of your withdrawal automatically — typically 20 percent for lump-sum distributions — and send it to the IRS on your behalf. But withholding is not the same as your final tax bill. Depending on your income that year, you might owe more tax when you file your return, or you might get a refund.

Key Takeaways

  • Traditional 401(k) withdrawals are taxed as ordinary income at your regular tax rate, on the full amount withdrawn.
  • Your employer will usually withhold 20 percent automatically, but this is not your final tax bill — you may owe more or less when you file.
  • Withdrawals before age 59½ are subject to an additional 10 percent penalty tax, unless you may have access to for a narrow exception.
  • Roth 401(k) withdrawals are tax-free if you have held the account for at least five years and are age 59½ or older.
  • The amount you withdraw counts as income for the year, which can affect your may be able to access for other tax credits and deductions.

Early withdrawals before age 59½ carry a 10 percent penalty

If you withdraw money from your 401(k) before you turn 59½, you will owe a 10 percent penalty tax on top of the ordinary income tax. This penalty applies to the amount you withdraw, not to your entire balance. So if you withdraw $10,000 early, you pay 10 percent of that $10,000 — $1,000 — as a penalty, plus income tax on the full $10,000.

The IRS does allow some exceptions to this penalty. You can withdraw without penalty if you are permanently disabled, if you are withdrawing to pay unreimbursed medical expenses that exceed 7.5 percent of your adjusted gross income, or if you are receiving distributions as part of a may have access to domestic relations order (usually in a divorce). Some plans also allow withdrawals for financial hardship, though the rules vary by plan and the IRS definition of hardship is narrow.

If you leave your job, you may be able to roll your 401(k) into an IRA or into your new employer's plan instead of withdrawing it. A rollover avoids both the income tax and the penalty, because the money moves directly from one retirement account to another without passing through your hands.

Roth 401(k) withdrawals follow different rules

If your plan offers a Roth 401(k) option and you contributed to it, withdrawals of your contributions are never taxed — you already paid tax on that money when you earned it. Withdrawals of the earnings (the investment gains) are tax-free too, but only if you have held the Roth 401(k) for at least five years and you are age 59½ or older, permanently disabled, or withdrawing after death.

If you withdraw earnings before you meet those conditions, you will owe income tax on the earnings portion and a 10 percent penalty on that earnings portion. Your contributions always come out tax-free and penalty-free, no matter when you withdraw them.

Many people confuse Roth 401(k) rules with Roth IRA rules. They are similar but not identical. A Roth 401(k) requires the five-year holding period and the age 59½ threshold for earnings to be tax-free. A Roth IRA has a five-year rule too, but it is calculated differently and the age threshold does not explore to contributions.

Withholding is automatic but may not cover your full tax bill

When you request a withdrawal, your plan administrator will withhold federal income tax before sending you the money. For most lump-sum distributions, the withholding rate is 20 percent. For periodic distributions (regular payments over time), the withholding is based on the W-4 form you file with your plan, similar to how your employer withholds from your paycheck.

The 20 percent withholding is a floor, not a ceiling. If your total income for the year is high, your tax bracket may be higher than 20 percent, and you will owe additional tax when you file your return. If your income is low, you might have too much withheld and receive a refund. The withholding also does not account for state income tax, which many states charge on 401(k) withdrawals.

You can request additional withholding when you take the withdrawal, or you can make estimated tax payments throughout the year. If you expect to owe a lot of tax, it is worth doing the math with a tax professional before you withdraw, so you are not surprised at tax time.

Your withdrawal counts as income for other tax purposes

The money you withdraw from your 401(k) is added to your total income for the year. This can push you into a higher tax bracket, which means you pay a higher rate not just on the withdrawal but on all your income. It can also affect your may be able to access for other tax benefits.

For example, if you are receiving Social Security benefits, a large 401(k) withdrawal might cause some of your benefits to become taxable. If you are claiming education credits or the child tax credit, the extra income from the withdrawal might reduce the amount of the credit you can claim. If you are trying to stay under an income threshold for a tax deduction, a withdrawal could disqualify you.

This is another reason to think through the timing and size of a withdrawal before you take it. Spreading withdrawals across multiple years, or taking them in a year when your other income is lower, can reduce the tax impact.

Loans from your 401(k) are not withdrawals and are not taxed

Some 401(k) plans allow you to borrow money from your own balance. A loan is different from a withdrawal: you are borrowing your own money and you must repay it with interest. The loan itself is not taxable income, and you do not owe income tax or penalty tax on the amount you borrow.

However, if you leave your job and do not repay the loan, the outstanding balance is treated as a withdrawal. At that point, you will owe income tax and possibly the 10 percent penalty, depending on your age. The rules around loans vary by plan, so check with your plan administrator about whether loans are available, what the interest rate is, and what happens to the loan if you change jobs.

State income tax may explore to your withdrawal

Federal income tax is not the only tax you may owe. Most states that have an income tax also tax 401(k) withdrawals. A few states — including Pennsylvania, Illinois, and Mississippi — do not tax retirement income, including 401(k) withdrawals. But if you live in a state with income tax, your withdrawal will likely be subject to state tax as well as federal tax.

Your plan administrator may withhold state income tax automatically, or you may need to pay it when you file your state return. The rate varies by state. If you are moving to a different state, or if you are retired and living in a state different from where you worked, check the rules for both states, because the tax treatment can be complicated.

Frequently Asked Questions

Do I have to pay tax on the money I contributed to my 401(k)?

Yes. Your contributions were deducted from your paycheck before federal income tax was withheld, so they were never taxed as income when you earned them. When you withdraw them, the IRS taxes them as ordinary income. The only exception is if you contributed to a Roth 401(k), in which case your contributions are not taxed when you withdraw them.

What if I withdraw money and then change my mind?

You cannot undo a withdrawal. However, if you roll the money into an IRA or another 401(k) within 60 days, you can avoid the income tax and penalty. This is called a rollover. If you miss the 60-day window, the withdrawal is final and you owe the tax.

Can I avoid the 10 percent penalty if I am under 59½?

Only in specific situations: if you are permanently disabled, if you are paying may have access to medical expenses, if you are receiving payments as part of a divorce order, or if your plan allows hardship withdrawals. Some plans also allow withdrawals under Rule 72(t), which lets you take equal periodic payments without penalty if you follow strict rules. Talk to your plan administrator about what your plan allows.

Will my 401(k) withdrawal affect my Social Security benefits?

It can. If you are receiving Social Security and your total income (including the withdrawal) exceeds a certain threshold, up to 85 percent of your benefits may become taxable. The threshold is $25,000 for single filers and $32,000 for married couples filing jointly. A large withdrawal could push you over that limit.

Do I owe tax on money I borrowed from my 401(k)?

No. A loan from your 401(k) is not taxable. You only owe tax if you fail to repay the loan, at which point it is treated as a withdrawal. If you leave your job, check your plan rules about what happens to an outstanding loan — many plans require you to repay it within a short time or it becomes a taxable withdrawal.