How Your 401(k) Contributions and Withdrawals Are Taxed

Traditional and Roth 401(k)s Are Taxed Completely Differently

A traditional 401(k) lets you deduct contributions from your taxable income in the year you make them, which lowers your tax bill that year. When you withdraw money in retirement, those withdrawals are taxed as ordinary income at whatever tax rate applies then. A Roth 401(k) works backward: you contribute after-tax dollars (no deduction now), but withdrawals in retirement are tax-free, provided you meet the withdrawal rules.

The choice between them hinges on whether you expect to be in a higher or lower tax bracket in retirement. If you think you'll earn less in retirement than you do now, traditional makes sense—you dodge taxes at a high rate today and pay them at a lower rate later. If you think your retirement income will be similar or higher, or if you simply want tax-assistance programs later, Roth is worth considering.

Your employer may offer one, both, or neither. If your plan offers both, you can split contributions between them in the same year, as long as your total doesn't exceed the annual limit.

Key Takeaways

• Traditional 401(k) contributions reduce your taxable income this year, but withdrawals in retirement are taxed as ordinary income.
• Roth 401(k) contributions are made with after-tax dollars and produce no tax deduction, but may have access to withdrawals in retirement are completely tax-free.
• Your employer's matching contribution is always treated as traditional money, even if you contribute to a Roth 401(k).
• Withdrawals before age 59½ from a traditional 401(k) trigger a 10 percent early withdrawal penalty plus income tax, with limited exceptions.
• Required minimum distributions (RMDs) force you to withdraw and pay tax on traditional 401(k) balances starting at age 73, but Roth 401(k)s have no RMD during your lifetime.

How Traditional 401(k) Taxes Work During Your Working Years

When you contribute to a traditional 401(k), your employer withholds that amount from your paycheck before calculating federal income tax. The contribution itself does not appear on your taxable income for the year. If you earn $60,000 and contribute $7,000 to a traditional 401(k), you report $53,000 as taxable income on your tax return.

This tax break applies only to the contribution itself. Any earnings your account generates—dividends, capital gains, interest—are not taxed while they sit in the account. You pay tax on those earnings only when you withdraw the money in retirement.

Your employer may also contribute matching funds. If your employer matches 3 percent of your salary, that matching money is also treated as a traditional contribution and grows tax-deferred. You cannot choose to have employer matching go into a Roth 401(k); it always goes into the traditional side.

How Roth 401(k) Taxes Work During Your Working Years

A Roth 401(k) contribution comes from your after-tax pay. If you earn $60,000 and contribute $7,000 to a Roth 401(k), your employer still withholds $7,000 from your paycheck, but you report the full $60,000 as taxable income. You pay income tax on that $60,000 now.

Like a traditional 401(k), earnings inside a Roth 401(k) grow tax-free while the money stays in the account. The difference is that when you withdraw in retirement, you owe no tax on either the contributions you made or the earnings they generated.

Roth 401(k)s have no income limits. Unlike a Roth IRA, which phases out for high earners, anyone can contribute to a Roth 401(k) if their employer offers one. This makes Roth 401(k)s a valuable tool for people earning above the Roth IRA income limits who still want tax-free retirement savings.

Taxes on Withdrawals Before Retirement

Withdrawals from a traditional 401(k) before age 59½ are subject to income tax plus a 10 percent early withdrawal penalty, with narrow exceptions. If you withdraw $10,000 before 59½, you owe income tax on the full $10,000 plus $1,000 in penalty. The tax rate depends on your current income bracket.

The main exceptions to the 10 percent penalty are: separation from service at age 55 or later, disability, death (beneficiary withdrawals), substantially equal periodic payments (a complex calculation), and a few others. Hardship withdrawals—for medical bills, home purchase, or education—are taxed as income but do not trigger the 10 percent penalty, though your plan must offer this option and you must meet the plan's hardship definition.

Roth 401(k) withdrawals before 59½ are more complicated. You can withdraw your contributions (the after-tax dollars you put in) anytime without tax or penalty. Withdrawals of earnings before 59½ are taxed as income and hit with the 10 percent penalty, unless an exception applies. The IRS treats contributions and earnings separately, so you need to track which is which.

Taxes on Withdrawals in Retirement

Once you reach 59½, you can withdraw from a traditional 401(k) without the 10 percent penalty, but you still owe income tax on every dollar you take out. If your account balance is $500,000 and you withdraw $50,000, you report $50,000 as ordinary income and pay tax at your current rate.

Roth 401(k) withdrawals at 59½ or later are tax-free if the account has been open for at least five tax years. The five-year clock starts on January 1 of the year you made your first Roth contribution to any Roth 401(k) through your employer. If you opened a Roth 401(k) in 2020, you can take tax-free withdrawals starting in 2025, even if you are still working.

If you withdraw from a Roth 401(k) before the five-year rule is satisfied, earnings are taxed and penalized, but contributions come out tax-free. This is why the five-year rule matters more for earnings than for the money you contributed yourself.

Required Minimum Distributions and Tax Consequences

Starting at age 73, you must withdraw a minimum amount from a traditional 401(k) each year, calculated by dividing your account balance by a life expectancy factor published by the IRS. These withdrawals are called required minimum distributions (RMDs). If you do not take the full RMD, the IRS penalizes you 25 percent of the shortfall (reduced to 10 percent if you correct it within two years).

Every dollar of an RMD from a traditional 401(k) is taxable income. If your RMD is $40,000, you report $40,000 as income for the year. This can push you into a higher tax bracket and affect other tax items, like the taxation of Social Security benefits or Medicare premiums.

Roth 401(k)s have no RMD during your lifetime. You can leave the money untouched as long as you live, and it continues to grow tax-free. This makes Roth 401(k)s useful for people who do not need the money in retirement and want to pass tax-free wealth to heirs. Your beneficiaries will have RMDs after you die, but the withdrawals remain tax-free.

Tax Withholding and Estimated Taxes

When you withdraw from a 401(k), your plan can withhold federal income tax automatically. For a traditional 401(k), you can choose how much to withhold—from zero to 100 percent of the withdrawal. If you withdraw $5,000 and request 20 percent withholding, the plan sends you $4,000 and pays $1,000 to the IRS.

Withholding is not the same as paying your full tax bill. If you withdraw a large amount or have other income, withholding may not cover what you owe. You may need to make estimated tax payments during the year or face a penalty when you file your return.

Roth 401(k) withdrawals of contributions are not subject to withholding because they are not taxable. Withdrawals of earnings may have withholding applied if you request it, though the earnings portion is what triggers tax liability.

Conversions and Tax Implications

You can convert a traditional 401(k) balance to a Roth 401(k) if your plan allows it. The amount you convert is taxable income in the year of conversion. If you convert $100,000, you report $100,000 as ordinary income and pay tax at your current rate.

Conversions are useful if you expect tax rates to rise, want to lock in a lower rate this year, or want to reduce future RMDs. The tax bill is due when you file your return, not when you make the conversion. You can pay the tax from outside the account or have the plan withhold from the conversion amount, though withholding reduces the amount actually converted.

After conversion, the money follows Roth rules: it grows tax-free and can be withdrawn tax-free after 59½ and five tax years. Conversions are irrevocable as of 2018, so you cannot undo one if tax rates drop or your income changes.

Frequently Asked Questions

Do I pay taxes on my employer match?

Not when it goes in. Employer matching contributions are not taxed in the year they are made. You pay tax on the match when you withdraw it in retirement, just like your own traditional contributions. The match grows tax-deferred inside the account.

What happens to my 401(k) taxes if I change jobs?

You can roll a traditional 401(k) to a new employer's plan or to a traditional IRA without triggering taxes or penalties, as long as the money moves directly from plan to plan. If you cash out and take the money yourself, your old employer withholds 20 percent for federal tax, and you owe the full tax bill when you file your return. A Roth 401(k) can roll to a Roth IRA or a new employer's Roth 401(k) without tax consequences.

Can I avoid RMDs by not taking withdrawals?

No. RMDs are mandatory starting at age 73 for traditional 401(k)s and IRAs. Skipping an RMD triggers a 25 percent penalty on the amount you should have withdrawn. Roth 401(k)s have no RMD during your lifetime, but beneficiaries must take distributions after you die.

Is my 401(k) taxed differently if I retire early?

Early withdrawals before 59½ are taxed as ordinary income plus a 10 percent penalty, with limited exceptions. Reaching age 55 and separating from service is one exception that allows penalty-free withdrawals. Roth 401(k) contributions can always be withdrawn tax and penalty-free, but earnings are penalized until 59½.

How do I know what tax bracket my 401(k) withdrawal puts me in?

Your withdrawal is added to all other income you have that year—wages, Social Security, investment income, etc. The total determines your tax bracket. A tax professional or tax software can calculate this, or you can use the IRS tax tables. Large withdrawals can push you into a higher bracket, so some people spread withdrawals over multiple years to manage their tax bill.