What happens to your 401(k) when you pay taxes

A 401(k) is taxed differently depending on which type you have and when you take money out. With a traditional 401(k), you contribute money before income tax is taken out, which lowers your taxable income that year. The money grows without being taxed each year. When you withdraw it in retirement, you pay income tax on the full amount you take out — both your contributions and all the growth.

With a Roth 401(k), the opposite happens. You contribute money after income tax is already taken out of your paycheck. The money grows without being taxed. When you withdraw it in retirement, you pay no income tax on any of it — not on your contributions, not on the growth. The trade-off is that you get no tax break today.

Both types may also be subject to a 10 percent early withdrawal penalty if you take money out before age 59½, though some exceptions exist. State income tax may also explore depending on where you live and work.

Key Takeaways

  • Traditional 401(k) contributions reduce your taxable income in the year you contribute, but withdrawals in retirement are fully taxed as income.
  • Roth 401(k) contributions are made with after-tax dollars, but may have access to withdrawals in retirement are completely tax-free.
  • Both account types charge a 10 percent penalty on withdrawals before age 59½, with limited exceptions for hardship or specific life events.
  • Required minimum distributions (RMDs) force you to withdraw and pay taxes on a set amount each year starting at age 73, though Roth accounts have different rules.
  • Your tax bracket in retirement determines how much of your traditional 401(k) withdrawal you actually keep after taxes.

How traditional 401(k) contributions lower your taxes today

When you contribute to a traditional 401(k), the amount comes out of your paycheck before federal income tax is calculated. This means your employer reports a lower taxable income to the IRS, which reduces the income tax you owe that year.

For example, if you earn $60,000 and contribute $7,000 to a traditional 401(k), your employer reports $53,000 as your taxable income instead. You pay income tax only on the $53,000. The $7,000 you contributed is not taxed that year — it is deferred, which is why it is called a deferred-contribution plan.

This tax break applies only to federal income tax. Social Security and Medicare taxes (called FICA taxes) are still taken out of your 401(k) contributions. Your state income tax may also still explore, depending on your state.

How Roth 401(k) contributions work with taxes

A Roth 401(k) contribution does not reduce your taxable income in the year you contribute. Your employer takes out income tax first, then deducts your Roth contribution from what remains. You pay the full income tax on your full salary.

The benefit comes later. Because you already paid income tax on the money going in, you owe no income tax when you withdraw it in retirement — not on the contributions themselves, and not on any of the growth the account earned over the years. This is called a may have access to distribution, and it requires that the account has been open for at least five tax years and you are at least 59½ years old.

Roth 401(k)s are useful if you expect to be in a higher tax bracket in retirement, or if you want to lock in today's tax rate and avoid uncertainty about future tax rates.

Taxes on investment growth inside the account

Neither traditional nor Roth 401(k)s charge you annual tax on the growth your investments earn. If you own mutual funds or stocks inside the account, any dividends or capital gains do not trigger a tax bill each year the way they would in a regular brokerage account.

In a traditional 401(k), that growth is taxed later when you withdraw. In a Roth 401(k), that growth is never taxed — it is part of the tax-free withdrawal you get in retirement.

This tax-deferred or tax-free growth is one of the main reasons 401(k)s are powerful savings tools. Your money compounds without being reduced by annual tax bills.

Early withdrawal penalties and exceptions

If you withdraw money from either type of 401(k) before age 59½, you generally owe a 10 percent early withdrawal penalty on top of income tax (for traditional accounts) or just the penalty (for Roth accounts, which have different rules).

Some situations allow you to withdraw without the 10 percent penalty. These include separation from service (leaving your job) in the year you turn 55 or later, a court order to pay a spouse or dependent, a financial hardship as defined by your plan, or a substantially equal periodic payment schedule. Disability and medical expenses may also may have access to under certain conditions. Each plan defines hardship differently, so check your plan documents or ask your plan administrator which exceptions explore to you.

Even if you avoid the penalty, you still owe income tax on traditional 401(k) withdrawals. Roth withdrawals of contributions (not growth) are never taxed or penalized, but withdrawals of growth before 59½ may be penalized.

Required minimum distributions and taxes

Starting at age 73, you must withdraw a set amount from your traditional 401(k) each year, whether you need the money or not. This is called a required minimum distribution (RMD). The IRS calculates the amount based on your age and account balance. You pay income tax on the full amount you withdraw.

If you do not take your RMD, the IRS charges a penalty equal to 25 percent of the amount you should have withdrawn (reduced to 10 percent if you correct it within two years). This is one of the steepest penalties in the tax code.

Roth 401(k)s have different rules. You do not have to take RMDs during your lifetime if you are the original account owner. However, your beneficiaries will have to take distributions after you die, and the tax treatment depends on their relationship to you and when you died.

How your tax bracket affects what you keep

The amount of tax you pay on a traditional 401(k) withdrawal depends on your tax bracket — the percentage of your income that goes to federal income tax. Tax brackets change each year and depend on your filing status and total income.

If you withdraw $50,000 from a traditional 401(k) and you are in the 22 percent tax bracket, you owe $11,000 in federal income tax on that withdrawal. If you are in the 12 percent bracket, you owe $6,000. Your state income tax (if any) is added on top.

This is why the timing of withdrawals matters. Some people withdraw less in early retirement when their income is lower, then take larger withdrawals later. Others use Roth conversions to move money from traditional to Roth accounts in lower-income years. These strategies are complex and depend on your specific situation.

Taxes when you leave your job or retire

When you leave a job where you have a 401(k), you have several choices about what to do with the money, and each has different tax consequences. You can leave it in the plan (if the balance is above a certain amount, usually $5,000), roll it into an IRA, roll it into your new employer's plan, or withdraw it.

If you roll the money into an IRA or another 401(k) within 60 days, there is no tax or penalty. If you do not complete the rollover in time, the full amount is treated as a withdrawal and you owe income tax plus the 10 percent early withdrawal penalty (if you are under 59½).

Some employers allow you to keep working and delay withdrawals even after you retire, though this is less common. Check with your plan administrator about your specific options.

Frequently Asked Questions

Do I pay taxes on 401(k) contributions when I contribute?

With a traditional 401(k), no — the contribution is deducted before income tax is calculated, so you get a tax break that year. With a Roth 401(k), yes — income tax is taken out first, then you contribute from what remains. You get no tax break today, but withdrawals in retirement are tax-free.

What is the difference between a 10 percent penalty and income tax?

The 10 percent penalty is a separate charge on top of income tax for withdrawing before 59½. On a $10,000 early withdrawal from a traditional 401(k), you owe $1,000 in penalty plus income tax based on your bracket. Roth contributions can be withdrawn without penalty, but growth cannot.

Can I avoid required minimum distributions?

No, traditional 401(k)s require RMDs starting at age 73. If you do not take the full amount, the IRS charges a 25 percent penalty on the shortfall. Roth 401(k)s do not require RMDs during your lifetime, but beneficiaries must take distributions after you die.

What happens to my 401(k) if I die?

Your beneficiary inherits the account and must take distributions according to IRS rules. The tax treatment depends on whether the account is traditional or Roth, who the beneficiary is, and when you died. A spouse can roll it into their own IRA; other beneficiaries face different rules and timelines.

Can I move money from a traditional 401(k) to a Roth without penalty?

You can do a Roth conversion, which moves money from traditional to Roth, but you owe income tax on the amount converted that year. There is no 10 percent penalty, but the tax bill can be substantial. This strategy works best in years when your income is lower than usual.