Understanding the Tax Implications of Retirement Account Contributions and Withdrawals

By Giselle Carratala

A recent survey of more than 27,000 Americans conducted by the FINRA Investor Education Foundation found that one in ten Americans have taken “hardship withdrawals” from their retirement accounts. As the April 17th deadline to file returns approaches, many of those individuals will be asking themselves the following question: will I have to pay taxes on my withdrawal? Generally, the answer to that question will be yes.

Contributions: Are They Tax-Free, Pre-Tax, or Tax-Advantaged?

Some retirement accounts, such as 401(k) plans, 403(b) plans, 457 plans, and IRAs provide individuals significant tax benefits to help them save for retirement. Generally, an individual won’t pay taxes on a contribution made to these accounts or on the contribution’s earnings (such as interest, dividends, and capital gains) until an individual withdraws money from the account. Contributing money to these accounts provides a “pre-tax” benefit because the contribution amount is subtracted from the employee’s paycheck before taxes are calculated. Therefore, an individual will pay tax on these contributions depending on her income tax rate at the time the withdrawal is made. Since most individuals have less income in their retirement years than in the years they are working, they generally will pay less taxes on the money they earned but set aside in a retirement account.

In addition, though some contributions—such as those made to a Roth 401(k) or Roth IRA—are not deducted from the investor’s income pre-tax, they are tax-advantaged. In the case of a Roth account, the advantage is that withdrawals made from this type of account are tax-free, if the account is open at least five years and the individual is at least 59½ years old. However, the same rule does not apply to other types of retirement accounts.

Taxes on Withdrawals

Generally, individuals are required to pay income taxes at their regular rate on early withdrawals they make from retirement accounts. In addition, the early withdrawal amount could be subject to a 10 percent tax penalty. The IRS recognizes some exceptions to the 10 percent tax penalty rule, including withdrawals made to pay for unreimbursed medical expenses or due to permanent disability of the account owner. A full list of penalty exceptions is available on the IRS website.

The tax implications vary depending on which type of retirement account an individual has. Owners of 401(k) accounts are required to pay income taxes on withdrawals if they are younger than 59½. However, owners of Roth 401(k) accounts are subject to slightly different rules. These account owners won’t be taxed on the principal in their accounts, but could be taxed on the investment earnings accumulated in their accounts. Nevertheless, Roth 401(k) withdrawals made after retirement age are considered “qualified withdrawals” and therefore are exempt from being taxed on earnings.

Given the potential additional tax liability and lost earnings, financial experts warn that withdrawals from retirement accounts should be a last resort and that investors should set aside some emergency funds in a regular savings account to help them cope with unforeseen circumstances. In addition, investors facing hardships who do not have or have already depleted their cash savings should consider other options before making an early withdrawal from their retirement account. For example, they may be able to take out a loan from their 401(k). Though taking out a loan from a retirement account will likely impact the account’s growth, the borrower may be able to avoid the tax penalties associated with an early withdrawal.