When you withdraw money from your 401(k), it’s called “taking distributions.” With most 401(k)s, as with IRAs, the IRS taxes your distribution as ordinary income, similar to how they tax your paycheck. The amount they deduct, however, depends on the type of your 401(k) and by the method and timing of your withdrawal.
Traditional 401(k)s and IRAs
How a traditional (or regular) 401(k) or IRA is taxed is quite simple. When you made contributions to the plan, they were made with pre-tax dollars, which reduced your taxable income, thus your income taxes, at that time. The taxes were deferred and become due once you start taking distributions.
For most people, distributions from traditional 401(k) and IRA plans are taxed as ordinary income, which means you are taxed at the rate for your tax bracket in the year you take the distribution. There are exceptions, however; for instance, if you were born before 1936 and withdraw your funds as a lump sum.
Since the IRS wants to receive the taxes at one point, required minimum distributions for both accounts must begin by age 70½.
What are the taxes on my 401(k) or IRA?
Just like your regular income, distributions from your traditional 401(k) or IRA are taxed on an incremental basis—the higher your income tier, the higher your tax rate. Currently, the basic structure contains seven tax brackets.
Let’s take the current tax year, 2019. A married couple that earns a total of $85,000 and filed jointly pays 10% tax on the first $19,400, 12% on the next $59,550, and 22% on the remaining $6,056.
Because the tax rate increases with your income tier, you should consider how your withdrawals may affect your tax bill when added to your other income. An example of other income is Social Security benefits, which typically aren’t subject to income tax; however, if your overall annual income is over a certain amount, Social Security benefits will become taxable. A sizeable IRA distribution could push your total income above that limit, so it’s important that you pay close attention to when and how you take distributions from your IRA or 401(k).
Roth retirement accounts – Roth 401(k)s and IRAs
The contributions to a Roth 401(k) or Roth IRA are made with after-tax dollars. Because you didn’t get a tax deduction at the time you made the contributions, your distributions will most likely not be taxed as long as they are qualified.
Your distributions qualify if your Roth has “aged” sufficiently (5 years) from the time you made your contributions, and if you are old enough (59½) to not incur a penalty on your withdrawals.
For Roth 401(k)s and IRAs, required minimum distributions must begin by age 70½, just like for traditional 401(k)s and IRAs. You are not totally in the clear tax-wise, though. If your employer matched your contributions to your Roth account, the IRS considers those contributions to be made with pre-tax dollars, which means you must pay taxes on that money (taxed as ordinary income) when you make a withdrawal.
Special Tax Strategies for 401(k)s and IRAs
Some taxpayers can employ tax strategies to lower their taxes on distributions. IRAs that hold physical precious metals employ opportunities to reduce taxation significantly upon distribution. Getting stocks in the company that gives you a 401(k) plan is another way people use. It’s best to discuss these with your advisers prior to making any decision.
Roll Over Your Funds
Rolling over a qualified retirement account carries no penalties or tax consequences. If the rollover is direct (the funds go from one institution to another), you incur no additional taxes. If it is an indirect (the funds are distributed to you), you must deposit the funds in your new IRA account within 60 days to avoid taxation.
About Fred Abadi
In his over 14 years in the financial industry, Fred has focused on commodities and precious metals as investment assets. He has penned several articles on topics such as the commodities markets and investing in precious metals for retirement accounts. Fred has helped thousands of clients safe-guard their investments with gold and other precious metals. He has been with Gold Alliance for over two years as a leading Sr. Portfolio Manager.