Whether you’re approaching retirement age or have decades to go, hopefully you’re stocking money away into your 401(k). Regardless of what happens in the future with Social Security, your 401(k) will likely be your primary source of income.
Understanding just how 401(k) accounts work and how withdrawals are taxed is essential so that you can make the money last for the length of your retirement. Below, find out how your 401(k) withdrawals are taxed in different scenarios.
How taxes affect your 401(k) income in retirement
401(k) accounts are powerful tools that offer upfront tax savings. Any money that you contribute to a 401(k) is deposited on a pre-tax basis, which can help lower your tax bill during your working years when your income is typically higher.
However, withdrawals work very differently than contributions. Once you start withdrawing from your 401(k), your withdrawals are taxed as ordinary income. That means your withdrawals are taxed at the same rate as other sources of income, such as your W-2 employment.
Most retirees live on less in retirement than they did in their working years, so you may be at a lower tax bracket. However, you need to account for taxes when deciding how much to withdrawal to maintain your standard of living.
How taxes impact your total income
Depending on your tax bracket, you could end up losing a substantial amount of your income. Under the new tax plan, there are seven tax brackets. If you withdrew $30,000 from your 401(k), you would fall into the 12% tax bracket, meaning you’d have less than the original $30,000 after taxes.
401(k) withdrawals are taxed like ordinary income
|Tax rate||Single filers||Married filing jointly or qualifying widow/widower||Married filing separately||Head of household|
|Tax rate: 10%||Single filers: Up to $9,325||Married filing jointly or qualifying widow/widower: Up to $18,650||Married filing separately: Up to $9,325||Head of household: Up to $13,350|
|Tax rate: 15%||Single filers: $9,326 to $37,950||Married filing jointly or qualifying widow/widower: $18,651 to $75,900||Married filing separately: $9,326 to $37,950||Head of household: $13,351 to $50,800|
|Tax rate: 25%||Single filers: $37,951 to $91,900||Married filing jointly or qualifying widow/widower: $75,901 to $153,100||Married filing separately: $37,951 to $76,550||Head of household: $50,801 to $131,200|
|Tax rate: 28%||Single filers: $91,901 to $191,650||Married filing jointly or qualifying widow/widower: $153,101 to $233,350||Married filing separately: $76,551 tp $116,675||Head of household: $131,201 to $212,500|
|Tax rate: 33%||Single filers: $191,651 to $416,700||Married filing jointly or qualifying widow/widower: $233,351 to $416,700||Married filing separately: $116,676 to $208,350||Head of household: $212,501 to $416,700|
|Tax rate: 35%||Single filers: $416,701 to $418,400||Married filing jointly or qualifying widow/widower: $416,701 to $470,000||Married filing separately: $208,351 to $235,350||Head of household: $416,701 to $444,550|
|Tax rate: 39.6%||Single filers: $418,401 or more||Married filing jointly or qualifying widow/widower: $470,001 or more||Married filing separately: $235,351 or more||Head of household: $444,551 or more|
What to expect if you do an early withdrawal
The IRS defines an early withdrawal as taking cash out of your retirement plan before you’re 59½ years old. In most cases, you will have to pay an additional 10 percent tax on early withdrawals unless you qualify for an exception. That’s on top of your normal tax rate.
If you quit your job, you can roll over your 401(k) to an Individual Retirement Account (IRA) or you can cash it out. If you cash it out, that qualifies as an early withdrawal, and it’s subject to an additional 10% tax as a penalty. That penalty could eat up thousands of dollars. Worse, you’d lose out on interest and market growth.
Pretend you are 30 years old and have a 401(k) balance of $10,000. Even if you made no more contributions and earned annual returns of 6%, your 401(k) would be worth $60,371 by the time you were 60. Without doing anything, your money would grow by over $50,000. If you instead cashed out at your 401(k) at 30, you’d lose out on all that money.
If at all possible, it’s wise to skip the early withdrawal and to keep your money working for you in your 401(k) until you reach retirement age.
Making your 401(k) last through your retirement
As you plan for retirement, it’s important to keep in mind that you’ll likely owe a significant amount of your income in taxes. That’s why it’s a good idea to save aggressively now, while you still have time, so you have enough income to retire later on. Understanding how taxes will affect your income in retirement can be a powerful savings motivator.
If you’re close to retirement age and your savings are not quite where they should be, check out these six last-minute retirement planning strategies to help you get on track.