Do 401(k) Withdrawals Count as Income? The Tax Implications, Explained
In the U.S., 401(k) has grown to become the most popular workplace retirement savings plan. If you're preparing your taxes and have a 401(k) plan, you might be wondering if withdrawals count as income.
A 401(k) is a retirement plan offered by employers. It's a defined-contribution plan mostly funded by employee contributions through pre-tax paycheck deductions. Employers might or might not match part of the contributions.
Workings of a 401(k) plan
A 401(k) plan puts the longevity and investment risk on individual employees. They're required to select their own investments with no assured maximum or minimum benefits. The funds contributed are usually securities, such as stocks and bonds, so that the money can grow over time. Depending on the plan your company provides, you may be able to choose where your contribution is invested.
The IRS sets the contribution limit for 401(k) plans and reviews it regularly. In 2022, you can contribute up to $20,500 to a 401(k) plan, up from $19,500 in 2021 and 2020.
Withdrawals from 401(k) plans are considered income
With a traditional 401(k), you make tax-free contributions to the fund, meaning the contributions are deducted from your paycheck before taxes are paid on that income. Therefore, contributing to a 401(k) reduces your current taxable income, which means a lower tax bill while your money grows tax-free in the plan—gains in 401(k) accounts, such as interest or dividends, are tax-deferred. However, withdrawals in retirement will be taxed as ordinary income at the application rate.
Contributions to 401(k) plans are made from pre-tax dollars
The rationale behind tax-deferred retirement savings is that a person’s income tax bracket should be lower when they aren't working. This way, people can benefit by paying lower income tax in their retirement years.
In contrast to contributions to traditional 401(k) plans, contributions to Roth 401(k) plans are taken after taxes. Therefore, your taxable income isn't reduced when you contribute to it. However, your withdrawals from this account are tax-exempt.
Premature withdrawals from 401(k) plans and their tax treatment
There's a 10 percent penalty if you withdraw funds from a 401(k) plan, individual retirement account (IRA), or any other tax-deferred retirement account before you turn 59-and-a-half. If you take out a premature distribution, it's considered a loan rather and needs to be paid back with interest. At this point, it doesn’t incur a penalty and isn't taxable. However, if you don't pay back the full balance within five years, it's considered a withdrawal, incurring a penalty and income tax.